November 26, 2019
Rhode Island’s New SALT
(State & Local Tax) Workaround
“The SALT cap limits the amount of allowable personal and state deductions. This workaround can lead to Federal tax savings, but time is of the essence. Here's what you need to know.”
The Tax Cuts and Jobs Act, which passed in December 2017, limits the amount of personal state and local taxes that can be deducted as an itemized deduction on Schedule A to $10,000 — commonly known as the SALT cap. This provision has had a significant increased tax cost to some taxpayers residing in states that impose an income tax. In an attempt to mitigate the increased Federal tax cost to resident taxpayers, some states have enacted state provisions to potentially circumvent these new Federal provisions.
As part of Rhode Island’s 2020 budget bill effective this past July 1, the state enacted a new optional entity-level tax which, according to the State, would convert potentially otherwise nondeductible Federal personal state income taxes to deductible business state income taxes. This new provision is contained in Rhode Island General Laws Section 44-11-2.3. Connecticut enacted a similar entity tax but it is mandatory, not elective.
This new Rhode Island optional entity-level tax is equal to 5.99% (the highest rate of the graduated RI individual income tax) of taxable income and is available to pass-through entities such as partnerships, limited liability companies and S corporations as well as single member limited liability companies and sole proprietors of business or rental activities.
The following summarizes the means to facilitate the use of this new Rhode Island legislation as well as the potential Federal exposure.
This provision requires an annual election so a taxpayer could adopt the provisions one year and not the next.
The taxpayer must pay the tax (i.e. 5.99% of business taxable income) by December 31, 2019. The state has said that they will not assess underpayment penalties in 2019 but quarterly estimated tax payments will be required for 2020.
This tax would be reported on the owners Federal K-1 as a conventional business expense (i.e. circumventing the SALT cap) and passed through to the owners on their State K-1 as a state credit to offset their Rhode Island personal income taxes. The state tax will not be deductible on the owners personal Rhode Island tax return, it will be an add-back. Note that the required entity taxes, calculated on an annual basis, cannot be reduced by any personal Rhode Island estimated payments or nonresident withholding payments you may have already paid. Any such excess Rhode Island estimated tax payments can either be refunded or applied to 2020. If you ultimately decide to take advantage of this provision, you should reevaluate the need to pay your fourth quarter Rhode Island estimated tax payment that is due January 15.
File an additional Rhode Island entity return (not released to date by the state).
The potential Federal tax savings of the SALT workaround depends on several factors, most importantly your marginal Federal income tax bracket. The higher the tax bracket, the greater the benefit. Currently, the highest marginal individual Federal income tax rate is 37%. The SALT workaround is tax neutral from a Rhode Island standpoint.
Potential Federal savings can be illustrated as follows.
Entity business income of $1,000,000 would require a $59,900 RI tax payment by December 31 that would save about $22,000 ($59,900 at 37%) in Federal taxes.
Entity business income of $100,000 would require a $5,990 RI tax payment that would save about $2,200 ($5,990 at 37%) in Federal taxes.
What is the Potential Federal Exposure?
It appears very likely that the Internal Revenue Service will review the Rhode Island statute, specifically or in a generic sense, to determine if the state tax income payment is truly a business expense, as the state is advocating, or is the state tax deduction subject to the SALT cap.
Possible arguments by the IRS that the state tax payment is not deductible as a business expense are the following:
Since the entity-level tax is elective, it is not an ordinary and necessary business expense which is a requirement every deductible business expense must meet.
The IRS in Revenue Procedure 2019-12, addressed SALT workarounds using payments to municipalities as charitable contributions and it appears that such payments that can offset state income taxes will not be allowed as a charitable contribution.
If the entity elects to pay the tax and pass through the deduction, and the IRS eventually publishes guidance that these state tax payments are not deductible, amended entity and individual returns should be filed reporting the additional taxes owed along with the associated penalties and interest. Such penalties could include a late payment penalty.
Although the potential certainty of success of the SALT workaround is dependent on future guidance by the IRS, we have some degree of skepticism until such guidance is issued. Ultimately, the decision is yours although we are here to assist you in the decision making progress.
Since time is of the essence and payment must be made by December 31, if you would like to pursue this, please contact us no later than Friday, December 6 so we can proceed.