NJ Enacts Pass-Through Business Alternative Income Tax
New Jersey has enacted legislation creating:
- an elective entity-level alternative income tax (AIT) for pass-through businesses; and
- an offsetting credit to taxpayers who receive income from a pass-through business paying the alternative tax.
The new law takes effect immediately and applies to tax years beginning after 2019.
The new law is New Jersey’s latest response to the controversial $10,000 limitation on individual state and local tax deductions introduced by the federal Tax Cuts and Jobs Act of 2017 (TCJA). The federal limitation applies for tax years beginning after December 31, 2017 and before January 1, 2026. The TCJA does not limit the deduction of state and local taxes for business entities and New Jersey’s new law seeks to bring parity to the treatment of business taxes paid by PTEs and business entities traditionally subject to tax on entity level income.
As designed, an electing PTE would deduct the AIT when determining its federal income. Allowing a PTE to deduct its AIT as a business tax at the entity level reduces the owners’ distributive share of federal taxable income. The AIT is not deductible when computing the PTE’s New Jersey income.
Elective Entity-Level Alternative Income Tax
A pass-through entity with at least one member subject to New Jersey income tax on pass-through entity’s proceeds can elect to pay alternative tax. A pass-through entity is an S corporation, partnership, or a limited liability company. In order to pay at the entity level, all members of the entity must agree.
A pass-through entity paying the pass-through business entity income tax will be excluded from a combined group, and from filing a combined return, if:
- all of the members of the pass-through entity are taxpayers otherwise liable for the New Jersey gross income tax; and
- no business entity taxed as a corporation has a direct, indirect, beneficial, or constructive ownership or control of the pass-through entity.
An entity electing to pay the alternative tax must make a return on or before the 15th day of the third month after the close of the entity’s tax year. Estimated tax payments will be due on the 15th of the fourth, sixth, ninth, and first month after the close of the tax year.
The Entity Tax. An electing entity must pay tax on the sum of each owner’s share of distributive proceeds attributable to the pass-through entity for the taxable year. “Distributive proceeds” include the net income, dividends, royalties, interest, rents, guaranteed payments, and gains of a PTE from New Jersey sources which are taxable under the GIT.
The tax rate on the share of each distribution will be:
- 5.675%, if the distributive proceeds of the pass-through entity are less than $250,000;
- 6.52%, if the distributive proceeds of the pass-through entity are less than $1,000,000, but greater than or equal to $250,000;
- 9.12%, if the distributive proceeds of the pass through entity are less than $3,000,000, but greater than or equal to $1,000,000; or
- 10.9%, if the distributive proceeds of the pass through entity are greater than or equal to $3,000,000.
Taxpayers who are member of a business opting to pay the alternative income tax, are allowed a refundable gross income tax credit. The amount of the credit is equal to the member’s pro rata share of the tax paid. The credit is applied against the gross income tax liability of the member in the tax year. The credit allowed to a trust or estate can be allocated to beneficiaries or used against the liability of the estate or trust.
A corporation that owns a pass-through business opting to pay the alternative income tax is allowed business tax credit. The credit may be carried forward for up to 20 years. The amount of the credit will equal the member’s pro rata share of the tax paid. The credit cannot reduce the corporation’s tax liability below the statutory minimum.
IRS Reaction. Some commentators have raised federal tax concerns regarding optional PTE taxes, like that enacted by New Jersey. The IRS recently issued final rules prohibiting the use of state tax credits for donations made to charitable funds created under state programs. Yet the IRS has not addressed the federal deductibility of PTE-level taxes. It remains unclear whether the IRS will address the federal tax consequences of state PTE taxes. Until it does, there will be some uncertainty regarding the federal deduction of PTE taxes.