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Illinois Enacts Pass-Through Entity Tax to Help Partners and S Corporation Shareholders Avoid the $10,000 SALT Cap

Illinois enacted a pass-through entity tax (PTE Tax) that may be elected by partnerships and S corporations to permit a federal deduction of state income taxes that otherwise are limited to $10,000 per year from 2018 to 2025 by the Tax Cuts and Jobs Act of 2017 (TCJA). State income taxes paid by individuals, whether attributable to pass-through entity income or other income, are subject to the TCJA’s $10,000 “SALT Cap.”

In Internal Revenue Service (IRS) Notice 2020-75, the IRS announced its approval of the federal deduction of state PTE Taxes paid by the entity in circumstances where the partner or shareholder receives a state tax credit, and the PTE Tax essentially is paid in lieu of the state income tax otherwise imposed upon the partner or S corporation shareholder.

The new Illinois PTE Tax was signed into law by Governor JB Pritzker on August 27, 2021 (Public Act 102-658) and applies to taxable years ending on or after December 31, 2021, and prior to January 1, 2026. Eighteen other states have also enacted PTE Taxes and 14 of those (including Illinois) are effective for 2021.

TAX AT ENTITY LEVEL

The Illinois PTE Tax is imposed on electing partnerships and S corporations at a rate of 4.95%, the flat income tax rate applicable to individuals. The tax is imposed upon the Illinois net income of the partnership or S corporation, which is equal to Illinois base income after apportionment or allocation. As discussed below, partners and S corporation shareholders may claim a refundable Illinois credit equal to their distributive share of the Illinois PTE Tax paid by the partnership or S corporation. Illinois base income of a partnership or S corporation for purposes of the PTE Tax is computed without deduction of Illinois net loss carryovers or the standard exemption. It’s also computed after addback of the partnership subtraction modification for reasonable compensation of partners (including guaranteed payments to partners) and the subtraction modification for income allocable to partners or shareholders subject to the Illinois “replacement tax.” The PTE Tax does not affect the replacement tax computation.

The Illinois PTE Tax is paid by the partnership or S corporation on all of its Illinois net income after apportionment or allocation. As a result, any tax exempt owner of a partnership or S corporation may be required to file Illinois refund claims in order to recoup PTE Taxes paid at the entity level (including as estimated payments). In some cases, this may be avoided by forming an upper-tier partnership for partners that are not tax exempt. Other states have avoided this problem by permitting the PTE Tax to be elected on a partner-by-partner basis rather than for the entity as a whole (e.g., California) or by imposing the PTE Tax only upon income that is allocable to partners subject to the state’s personal income tax (e.g., New York State).

TIERED PARTNERSHIPS

In the case of tiered partnerships, if a lower-tier partnership makes the PTE Tax election, the upper-tier [...]

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Nebraska District Court Holds That GIL 24-19-1 is Not Afforded Deference

Last week, the Lancaster County District Court granted the state’s motion to dismiss in COST v. Nebraska Department of Revenue. COST brought this declaratory judgment action to invalidate GIL 24-19-1, in which the department determined that earnings deemed repatriated under IRC § 965 are not eligible for the state’s dividends-received deduction and are thus subject to Nebraska corporate income tax. COST has until July 19, 2021, to appeal the judge’s decision.

The state’s motion was brought on procedural grounds, one of which was that the GIL is a guidance document and not a “rule” such that a declaratory judgment was not permitted under Nebraska law. COST argued that although the GIL is labeled a guidance document, it is in substance a rule because it establishes a legal standard and explicitly penalizes taxpayers that do not comply. The district court determined that the GIL is not a rule and granted the state’s motion. The district court did not address the substantive issue of whether 965 income is eligible for the dividends received deduction.

While on its face this decision may seem to be a taxpayer loss, the language of the judge’s order suggests otherwise. In finding that the GIL is not a “rule,” the judge determined that the GIL was a mere interpretation of the law that was not binding on the taxpayer and not entitled to any deference by the Nebraska courts. This strengthens an already strong taxpayer case on the merits.

The department’s position that 965 income is not eligible for the dividends-received deduction is inconsistent with the legislative history of the deduction and the nature of 965 income. The fact that a judge stated that this position is now afforded no deference only makes the taxpayer case stronger.

As a practical matter, taxpayers that have appealed assessments on 965 income should consider including the deference argument in their appeals, and taxpayers that have followed the GIL and paid tax on 965 income may consider filing refund claims. The substance of this issue will be litigated one way or another, and the district court’s finding that the GIL is not afforded deference can only help the taxpayer case.




Indiana Tax Court Upholds Pharmacy Benefit Management Costs of Performance Approach

The Indiana Tax Court held that a “pharmacy benefit management company” sold services as opposed to tangible personal property for tax years 2011 through 2013. The company’s receipts were properly sourced as revenue from services under the income producing activity/costs of performance rule, which in this case meant that all receipts were sourced outside of Indiana.

The Indiana Department of Revenue (Department) argued that the pharmacy benefit management company’s “receipts from its sale of prescription drugs should have been sourced to Indiana as required for sales of tangible personal property under Indiana Code” because the company’s “primary ‘revenue stream’ was attributable to buying, selling, and delivering prescription drugs in transactions which occurred within [Indiana].”

The court disagreed with the Department, finding “[the pharmacy benefit management company’s] income was derived from providing pharmacy benefit management services and not from selling prescription drugs during the years at issue.” The court looked to the company’s Securities and Exchange Commission (SEC) Form 10-K filing, observing “[n]one of the emphasized words [in the Form] describe a sale of goods, but instead, describe services. Indeed, nowhere in the designated portion of [the company’s] Form 10-K does the text state that the [company’s] revenue is from the sale of prescription drugs, focusing on facilitating delivery as its discrete service, not as a function of selling a good” (emphasis in the original). On May 1, 2019, Indiana switched from its historical cost of performance sourcing methodology to a market-based sourcing for services, retroactive to January 1, 2019.




US Treasury Issues Guidance on the ARPA Claw-Back Provision

Earlier this week, the US Department of the Treasury (Treasury) issued formal guidance regarding the administration of the American Rescue Plan Act of 2021 (ARPA) claw-back provision. The guidance (Interim Final Rule) provides that the claw-back provision is triggered when there is a reduction in net tax revenue caused by changes in law, regulation or interpretation, and the state cannot identify sufficient funds from sources other than federal relief funds to offset the reduction in net tax revenue. The Interim Final Rule recognizes three sources of funds that may offset a net tax revenue reduction other than federal relief funds—organic growth, increases in revenue (e.g., a tax rate increase) and certain spending cuts (i.e., cuts that are not in an area where the recipient government has spent federal relief funds). According to the Treasury, this framework recognizes that money is fungible and “prevents efforts to use Fiscal Recovery Funds to indirectly offset reductions in net tax revenue.”

The Interim Final Rule also provides guidance on what is considered a change in law, regulation or interpretation that could trigger the claw-back (called covered changes), but that point remains somewhat ambiguous. The Rule provides that:

The offset provision is triggered by a reduction in net tax revenue resulting from ‘a change in law, regulation, or administrative interpretation.’ A covered change includes any final legislative or regulatory action, a new or changed administrative interpretation, and the phase-in or taking effect of any statute or rule where the phase-in or taking effect was not prescribed prior to the start of the covered period. [The covered period is March 3, 2021 through December 31, 2024.] Changed administrative interpretations would not include corrections to replace prior inaccurate interpretations; such corrections would instead be treated as changes implementing legislation enacted or regulations issued prior to the covered period; the operative change in those circumstances is the underlying legislation or regulation that occurred prior to the covered period. Moreover, only the changes within the control of the State or territory are considered covered changes. Covered changes do not include a change in rate that is triggered automatically and based on statutory or regulatory criteria in effect prior to the covered period. For example, a state law that sets its earned income tax credit (EITC) at a fixed percentage of the Federal EITC will see its EITC payments automatically increase—and thus its tax revenue reduced—because of the Federal government’s expansion of the EITC in the ARPA. This would not be considered a covered change. In addition, the offset provision applies only to actions for which the change in policy occurs during the covered period; it excludes regulations or other actions that implement a change or law substantively enacted prior to March 3, 2021. Finally, Treasury has determined and previously announced that income tax changes—even those made during the covered period—that simply conform with recent changes in Federal law (including those to conform to recent changes in Federal taxation of unemployment insurance benefits and taxation of loan [...]

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Kansas Decouples from GILTI and 163j

Yesterday afternoon the Kansas legislature overrode Governor Laura Kelly’s veto of Senate Bill (SB) 50, effectively enacting the provisions of the bill into law. Among those are provisions decoupling from certain Tax Cuts and Jobs Act (TCJA) provisions that taxpayers have been advocating for since 2018.

Under the new law, for tax years beginning after December 31, 2020, taxpayers receive a 100% deduction for global intangible low-taxed income (GILTI) included in federal income. Furthermore, the new law is explicit that foreign earnings deemed repatriated and included in federal income under IRC § 965 are considered dividend income and eligible for the state’s 80% dividend-received deduction. The new law also decouples from the interest expense deduction limitation in IRC § 163(j), enacted as part of the TCJA for tax years beginning after December 31, 2020.

A Kansas decoupling bill was first proposed in 2019. Decoupling efforts faced an uphill battle because of the Kansas legislature’s reluctance to pass laws that could be perceived as tax cuts. The 2019 bill was vetoed by Governor Kelly, but that bill was not overridden by the legislature. The STARR Partnership and its members have worked closely with the Kansas Chamber of Commerce on the Kansas decoupling efforts and finally, in this legislative session, advocates were able to persuade the legislature that the decoupling provisions were not tax cuts but provisions designed to prevent a tax increase. This is a great result in Kansas and serves as a welcomed reminder that states that tax GILTI and 965 income (cough, cough, Nebraska) are outliers.




The US Department of the Treasury Says State IRC Conformity Bills Do Not Trigger Federal Relief Claw-Back Provision

As we’ve blogged about in the past, the recently enacted American Rescue Plan Act of 2021 (ARPA) includes an ambiguous claw-back provision. If broadly interpreted, it could result in states losing relief funding provided under the APRA if there is any state legislative or administrative change that results in the reduction of state revenue. This provision is causing havoc in the state tax world, rightfully so.

After much yelling and screaming from state attorneys general and those in the tax world, including McDermott (see McDermott letter to Treasury Secretary Janet Yellen attached), the US Department of the Treasury issued a press release announcing forthcoming “comprehensive guidance” on this provision. Treasury also addressed a question that has been on the top of our minds since the provision was enacted: Could state legislation addressing state conformity to the Internal Revenue Code trigger the claw-back? States routinely conform to and decouple from changes to the Internal Revenue Code, so if such actions could trigger the claw-back, state legislatures would be reluctant to consider them. We were so concerned about this issue that we specifically addressed it in our letter to Secretary Yellen.

This week, we received the Treasury’s guidance on this issue: Conformity bills will not trigger the claw-back. In its press release, Treasury stated:

… Treasury has decided to address a question that has arisen frequently: whether income tax changes that simply conform a State or territory’s tax law with recent changes in federal income tax law are subject to the offset provision of section 602(c)(2)(A) of the Social Security Act, as added by the American Rescue Plan Act of 2021. Regardless of the particular method of conformity and the effect on net tax revenue, Treasury views such changes as permissible under the offset provision.

This is a step in the right direction and should ease concerns of state legislatures. Passing a conformity bill will not cause any loss of federal funding. Treasury’s guidance, because it applies to all “methods of conformity,” should cover any legislation that either couples with or decouples from the Internal Revenue Code.

But our work is not done. In our letter to Secretary Yellen we also asked for guidance confirming that state actions in other areas will not trigger the claw-back. Specifically, we made concrete suggestions that actions to correcting tax statutes or rules that are either unconstitutional or barred by or violate federal law also should not trigger the claw-back. Treasury’s recent press release gives us a glimmer of hope that Treasury will exclude such actions from the clutches of the claw-back provision as well. Stay tuned for more!




McDermott Provides Treasury Department with Concrete Suggestions for Guidance on the American Rescue Plan Act’s Claw-Back Provision

The recently enacted American Rescue Plan Act of 2021 (ARPA) includes an ambiguous claw-back provision that has brought the world of state and local tax policymaking to a grinding halt. Because ARPA’s adoption occurred during the final weeks of many states’ legislative sessions, rapid issuance of guidance from the US Department of the Treasury is needed before the sessions adjourn to prevent the irreversible damage that will occur if a state foregoes enacting policies aimed at alleviating the economic disruption caused by COVID-19 out of fear of facing claw-back of federal relief.

McDermott recently sent a letter to Treasury Secretary Janet Yellen, urging the issuance of guidance giving a balanced interpretation of the claw-back provision. This guidance is necessary to avoid putting state legislatures, governors and tax administrators across the country in an untenable situation where every tax change or adjustment being considered—no matter how innocuous or routine—will carry the risk of a reduction to their state’s share of federal funding for the next three years.

In the letter, we provided concrete suggestions on areas where the ARPA left room for such balanced interpretation. We suggested that Treasury interpret the claw-back provision as either inapplicable to or provide a safe harbor for:

  • Changes addressing state conformity to the Internal Revenue Code (IRC)
  • Corrections of unconstitutional tax statutes or rules
  • Corrections of tax provisions barred by or that violate federal law
  • Actions in which there is no or only a weak connection between the law change reducing net revenue and the use of federal relief funds
  • Changes in the law announced before the enactment of ARPA
  • Reductions in net revenue related to purposes that further ARPA’s objectives.

The letter pointed out that states need concrete guidance, whether formal or informal, addressing these areas. Such guidance will alleviate the concerns of state governments and allow state policymakers to function and continue the orderly administration of state taxes.




Federal COVID-19 Relief Bill Brings State Tax Policy to a Grinding Halt

On March 11, 2021, US President Joe Biden signed the American Rescue Plan Act of 2021 (ARPA), the COVID-19 relief bill that includes $350 billion in relief to states and localities. To prevent states from using federal relief funds to finance tax cuts, Congress included a clawback provision requiring that any relief funds used to offset tax cuts during the next three years be returned to the federal government. Here is the text of the provision:

  • A State or territory shall not use the funds provided under this section or transferred pursuant to section 603(c)(4) to either directly or indirectly offset a reduction in the net tax revenue of such State or territory resulting from a change in law, regulation or administrative interpretation during the covered period that reduces any tax (by providing for a reduction in a rate, a rebate, a deduction, a credit or otherwise) or delays the imposition of any tax or tax increase.

This language broadly prohibits states from taking legislative or administrative action through the end of 2024 that reduces state tax revenues by any means (deduction, credit, delay, rate change, etc.) if doing so could be characterized as the use of federal relief funds to offset, directly or indirectly, the tax reduction. Practically speaking, this limitation will completely hamstring state and local governments from the normal ebb and flow of tax policy changes, adjustments and interpretations. Taken to its logical conclusion, this language freezes state legislative and administrative tax policy development out of fear anything they may do would require the return of federal relief funds. We expect the US Department of the Treasury will issue guidance clarifying this provision in the coming weeks.

Practice Note: This provision of ARPA is, in our view, the most significant federal pre-emption of state tax policy in history. For the next three years, legislators and tax administrators alike will be scrutinized as their tax policy decisions are evaluated through the lens of this prohibition. This level of congressional control over state tax policy decisions and fiscal autonomy likely violates the Tenth Amendment of the US Constitution and would dismay the framers’ basic notions of federalism.

While Congress has the ability to limit the use of federal funds in ensuring its policy goals are accomplished, the overly broad state tax limitation adopted by Congress goes far beyond its stated purpose and prevents states from furthering ARPA’s goals by using tax policy to craft their own COVID-19 relief measures. Any regulation or administrative interpretation that reduces state tax revenue or delays the implementation of a tax is, effectively, barred by the unprecedented intrusion into state tax policy-making.

The effects of ARPA’s state tax limitation are immediate and far-reaching. It will chill continuing state efforts to couple/decouple state tax codes to or from the Tax Cuts and Jobs Act of 2017. Additionally, ARPA already stalled legislation pending in Maryland that would delay, for one year, implementation of its digital advertising services gross receipts tax, restoring return filing and tax [...]

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Connecticut Bill Aims to Address the Impact of Telecommuting during the Pandemic

As we continue to face growing concerns because of the nationwide impact of COVID-19, taxpayers should be mindful of the potential impacts that the continued rise in telecommuting may have on their state personal income tax liabilities.

A bill was recently introduced in Connecticut that partially addresses this situation. Connecticut House Bill No. 6513 (HB 6513) clarifies that Connecticut residents will not face double taxation on their 2020 taxes and will instead receive a credit against their Connecticut personal income taxes for taxes paid in other states even if the resident, because of COVID-19, was working remotely from Connecticut rather than from their usual out-of-state office. HB 6513 further states that the Connecticut Department of Revenue Services, in determining whether an employer has nexus with Connecticut for purposes of the imposition of any Connecticut tax, shall not consider the activities of an employee who worked remotely from Connecticut solely because of COVID-19.

HB 6513 passed in the 151-member Connecticut House of Representatives on February 24, 2021, and passed in the 36-member Connecticut State Senate on March 1, 2021. The bill now heads to the state governor’s desk for signature. While it is expected that the Governor will sign the bill, passage of the bill still leaves taxpayers with uncertainty for 2021. Many taxpayers nationwide are likely to continue working remotely (from states other than where their usual offices are located) for the foreseeable future, and absent Congressional legislation or a Supreme Court decision, this state income tax issue does not seem likely to abate any time soon.




New York Issues Much-Anticipated Guidance on Taxation of Telecommuting Employees

Since the outset of the COVID-19 pandemic and work-from-home mandates, New York employers and their nonresident employees have been waiting for the Department of Taxation and Finance to address the million-dollar question: Do wages earned by a nonresident who typically works in a New York office but is now telecommuting from another state due to the pandemic constitute New York source income? New York has historical guidance concerning the application of its “convenience of the employee/necessity of the employer” test, the test used to determine whether a telecommuting nonresident’s wages are sourced to New York, but until recently the Department had been silent as to whether or how such rule applied under the unprecedented circumstances of the COVID-19 pandemic.

As many expected, in a recent update to the residency FAQs, the Department clearly stated its position that a nonresident whose primary office is in New York State is considered to be working in New York State on days that he or she telecommutes from outside the state during the pandemic unless the employer has “established a bona fide employer office at [the] telecommuting location.” The Department adopted the “bona fide employer office” test in 2006 as its way of applying the convenience of the employee rule to employees that work from home. The bona fide employer office test is a factor-based test and, for the most part, a home office will not qualify as a bona fide employer office unless the employer takes specific actions to establish the location as a company office. (See: TSB-M-06(5)I, New York Tax Treatment of Nonresidents and Part-Year Residents Application of the Convenience of the Employer Test to Telecommuters and Others.) As is apparent in the FAQ, the Department is mechanically applying this test to employees working from home as a result of the pandemic and is not providing any special rules or accommodations for employees that have been required or encouraged by New York State and local governments to telecommute.

Interestingly, the Massachusetts Department of Revenue took a similar approach to New York’s by promulgating a regulation requiring nonresidents that typically work in Massachusetts but are telecommuting from outside the state to pay tax on their wages. On October 19, 2020, New Hampshire filed a Motion for Leave to File Bill of Complaint with the United States Supreme Court challenging the constitutionality of Massachusetts’ regulation. We understand that New Jersey is considering joining New Hampshire in this lawsuit based on New York’s recent guidance, which would require many New Jersey residents to pay New York income tax even though they are no longer working in New York. The US Supreme Court has twice declined to rule on the constitutionality of the convenience-of-the-employee test, so stay tuned on this important development.




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