New Tax Option Can Lift Small Business Tax Burdens

Much has been written about taxes in New Jersey, where we continue to be among the highest-taxed states in the nation – and taxes continue to rise. That’s not a good place for our state to be. But there is some good news for pass-through business owners. 

Most New Jerseyans are familiar with the millionaires tax. However, a lesser-known tax change called the Pass-Through Business Alternative Income Tax Act (BAIT), that actually reduces taxes on business owners by about the same amount as the millionaires tax will raise them, gets little attention and celebration. And here is the best part: the tax reduction is revenue neutral to the state while saving taxes for New Jersey business owners. Effective in 2020, BAIT actually reduces the cost of New Jersey income taxes for business owners by up to one-third. It applies to entities such as sub chapter S corporations, partnerships and limited liability companies (LLCs). 

The Background 

In 2017, the federal government passed the Tax Cut and Jobs Act (TCJA) that, among other things, reduced the deduction of state and local taxes (SALT) to a maximum of $10,000 per year. 

Many small businesses are formed as so-called “pass-through entities,” including S corporations, LLCs, partnerships and more. Tax advisors have recommended utilizing pass-through entities for decades because they offer an efficient and effective method for reducing tax rates on small and midsize companies. Pass-through entities generally make good tax sense, as opposed to forming a C corporation where long-term double taxation can be very expensive for a business owner. 

In a pass-through entity, an owner is typically responsible for reporting his or her share of company profits on individual tax returns and paying taxes on that income. It is common that while the individual is responsible for the payment of the tax, the funds are generally provided by the pass-through entity through distribution of the profits that created the individual-level tax. 

And this is where the SALT limitation under TCJA created a challenging tax issue for business owners. Since the businesses were not directly paying the tax, the individual business owners were no longer able to deduct, for federal income tax purposes, state and local taxes on the taxable income of the business. It effectively eliminated the deduction of an ordinary and necessary expense of a business, thereby increasing the effective tax rate of the business. This represented a penalty on business owners of these legitimate forms of business and was particularly harsh for New Jersey businesses. 

How the BAIT Works 

Starting in 2020, pass-through entities will be able to elect to be taxed in New Jersey at the entity level, which will create a full deduction of those taxes when computing federal taxable income. 

Adopting this as an elective tax was important to ensure that out-of-state business owners would not get double taxed for the same income in their resident state and thereby maintain the goal of revenue neutrality. 

Without getting too deep, it is typical that states permit credits for income taxes paid to other jurisdictions to avoid double taxation. Since the New Jersey BAIT is being paid by the entity, states will interpret and apply the principles of this type of entity tax and the corresponding credit that would have been available if the tax was paid by the individual owner differently. Therefore, making the BAIT elective permits planning to maximize the potential benefits and avoid the pitfalls of increased taxes. 

When the BAIT election is made, the New Jersey business owner’s individual tax return will apply a 100% credit for the entity taxes paid against their State of New Jersey income taxes to avoid assessing a tax on the same income in the state twice. 

Even though the New Jersey law seemed to be based in strong tax principles, some tax experts were concerned that the U.S. Treasury would not permit the deduction of state and local entity-level taxes, negating the benefits of the BAIT. Fortunately, in November 2020, the Treasury announced proposed regulations that provided certainty that entity-level taxes paid by pass-through businesses will be permitted as a deduction in computing federal taxable income. 

As the end of the year approaches, business owners should consult with their tax advisors on how to plan the best ways to leverage the BAIT to reduce their tax liabilities. New Jersey has a web page established to answer FAQs and a portal set up to receive payments: 

It’s not often that New Jersey can brag about reducing taxes on business owners, while at the same time not costing the New Jersey Treasury a dollar in lost revenues – and then have the workaround approved by the IRS. I would call that a win, win, win!

About the Author 

Alan D. Sobel, CPA, CGMA, is the managing member of SobelCo, LLC, and is the 2020/21 president of the NJCPA. His areas of expertise are financial reporting, tax planning for businesses and high net worth individuals, and strategic business planning. He can be reached at [email protected]. 

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