Yes, it’s tax season.

Which means many of you will be cursing under your breath again at the TCJA (Tax Cut and Jobs Act, sic- it was a tax cut for the rich with NO jobs whatsoever).  Why?  Because one of the hallmarks of this act was the virtual elimination of itemizing on one’s taxes.  Sure, the architects of this cornucopia of blessing for big business and the 1%-ers claim that it makes your tax filing easier.  (So does the very old joke as demonstrated by the IRS “form” below.)

But, the reality is by combining the former standard deduction with our exemptions meant that a family of four went from about a $ 26,000 reduction to their gross income to a $24,000 one.  But, more to the point, the old rules meant that one could itemize deductions that exceeded about $ 10,000 in total- and with property taxes, state income taxes (SALT), and mortgage interest, that was a fairly low threshold.  Now, that threshold is $ 24K- and NO state/local/property taxes above $ 10K can be included.

Which is why so many folks began renting out a portion of their homes.  Not only because they need the financial assistance (due to the tax INCREASES imposed) but because that meant part of their property taxes would be apportioned to Schedule E (Rental income),  thereby ‘increasing’ their ability to deduct their SALT from the incomes.

I had written about the approach that some states tried to let their residents more fully deduct their SALT.  But, the Feds squashed that (which also meant states like Alabama and West Virginia that had been using that wrinkle long before the enactment of TCJA got hit, as well).

Well, now there’s an even smarter response from New Jersey. One that the new governor (Phil Murphy) just signed into law.  But, it’s not for everyone.  (Sniff, sniff.)  Only for those folks who own pass-through entities.  These businesses are called pass-through because (except for CA, DC, DE, FL, HI, NM, NY, and WA) their incomes are never taxed at the business level, but ‘pass through’ to the owner’s personal incomes- and are taxed as individual incomes.   These include proprietorships (or DBA’s- doing business as- that report business income and expenses on the Schedule C of the 1040), partnerships (reporting their incomes on Form 1065), LLC’s (reporting on 1065’s, 1120s’, or even 1120’s- depending on how they’ve decided to align their entities), and S entities (corporations that have elected to be what used to be termed ‘small business designations, reporting on 1120S’.)  And, like the Feds just did with their end of year laws, this one is also retroactive to 1 January 2019.

The new law, the “Pass-Through Business Alternative Income Tax Act [PT-BAIT], lets those pass-through entities elect to pay income tax on their profits at this level.  Why would one do so?  Isn’t that EXACTLY why folks formed the pass-through entities in the first place- to bypass ‘double’ taxation?  (C Corporations are now taxed at the 21% rate; most stockholders then get taxed on the profits they take out of the corporation.)

Because this law entitles those who elect to pay their taxes at the business level to offset the SALT (state and local taxes) that would be due and owing from their personal taxes.  Which means if they can’t itemize (passing the $24K threshold), they could get some relief against their tax burden.  And, if they can itemize, the $ 10,000 limitation on SALT has been effectively pierced by splitting off part of their taxes to their business entities.

Of course, there are limitations.  The pass-through entity MUST have at least one member (partner, shareholder, member) who is a natural person.  (That means no “Citizen’s United persons- you know, the SCOTUS decision that businesses are people, too.)  In addition (this is, at least to me, self-evident) the individual owes gross income tax to the state- income, dividends, and gains from the pass-through entity as earned and sourced in the State of New Jersey.

Now, it’s not always going to be to the benefit of the member, though.

Because we use the member’s portion (each and every New Jersey resident [typically reported on the K-1, a sort of W-2 that businesses provide their members that describes their income (and some expenses)] )and then tax it at the MAXIMUM marginal rate that the state applies to income (currently 10.75%).  The individual computations are then added together to determine the business’ alternative income tax liability.  (If a member has a liability of less than $ 1 or owes no gross income tax in a given year, that member’s portion is disregarded as part of the alternative income tax liability).

The refundable gross income tax credit is applied to the members of the pass-through entity at the 89.25% of the member’s share.  (Why 89.25%?  Come on! Add 89.25% and the 10.75% tax rate.)

This is expected to save New Jersey taxpayers somewhere between $ 200KK and $ 400KK.  (This is the politicians’ claim.) Not exactly chicken feed.

I know you think that 10.75% is a pretty steep tax for this process.  But, overall, it’s reasonable (and a boon for the state of New Jersey). Those whose income is under $75K only get taxed at 5.75%; the next tranche up to $ 500K is only 6.37%.  But,  if we are talking about the ability to deduct $12,000 more in state tax deductions as we itemize, the numbers tell the story.

Taxable Income	Itemized Deductions	Federal Tax on that $12000 untaken state taxes	New Jersey Tax as a result	Net Effect
$75000	36000 (but limited to $24K- standard)	$2640	$690	$3330
$75K – $12K – $63K net	Full $ 36K ($24 on Fed but $12K less income)	– $2640	-$690+$1290= +$600	$2040 saving
$150K net	$36K          after NJ deal	–$2880	-$764.40+$1290= $525.60	$2354.40 saving

When the pass-through business pays this tax- and then deducts it as a business expense, the net income of the company is reduced.  Which also reduces the pass-through that the individual receives.  Which isd how the taxpayer now has a lower adjusted gross income on both federal and state tax levels.  

Any other states going to follow suit?