$10,000 State and Local Tax Limitation Workaround for Idaho Pass-through Entity Owners

Published on Friday, July 30, 2021

Since its inception in 2017, a major point of contention with the Tax Cuts and Jobs Act has been its limitation of the deduction for state and local taxes on individual returns to $10,000. This limitation, which includes state and local income taxes, real property taxes, and personal property taxes, has resulted in a number of taxpayer’s losing out on federal tax deductions they had previously been afforded, while others have been barred from itemizing on their returns altogether. In order to assuage some of the noted frustrations stemming from this change, on April 15, 2021 Idaho Governor Brad Little signed House Bill 317 (H.B. 317) into law, which allows for a workaround of the $10,000 cap for business owners. The bill permits Idaho state taxes on Idaho sourced pass-through entity income to be paid at the entity level, as opposed to passed through to the entity owners, where the state income tax paid by the owner would be subject to the limitation. The pass-through entity electing to be taxed at the entity level will be responsible for paying the Idaho state taxes due, resulting in a deduction to its member’s income at the federal level, while members of the pass-through entity will also have their pro rata share of Idaho taxes paid flow through onto their individual Idaho state return as a payment made to the state for the taxable year in question. There were inquiries as to whether the federal government would permit pass-through entities to deduct state income taxes paid at the entity level to be deducted at the federal level, but the IRS has upheld the deduction when it announced in notice 2020-75 that “state and local income taxes imposed on and paid by a partnership or an S-corporation on its income are allowed as a deduction.”

The election, which is made on a timely-filed original return for the taxable year and available for both partnerships and S-corporations, has the potential for profound tax savings for pass-through entity members. For example:

An Idaho taxpayer receives $200,000 in taxable Idaho sourced income from his share in a partnership, and pays individual state income tax of $13,000 (using Idaho’s new marginal rate of 6.5% as of May, 10 2021) on that partnership income, along with $5,000 in local property tax, for a total of $18,000 in state and local taxes. Without making the election for his partnership to pay his state income tax at the entity level, the $18,000 the taxpayer pays in state income and property tax is capped by the state and local limitation, thereby only allowing the taxpayer a $10,000 itemized deduction for his federal tax purposes. If the partnership instead elects to pay its members’ Idaho state income tax at the entity level, the taxpayer receives a full deduction at the entity level, reducing the amount of pass-through income he reports on his federal return by the full $13,000 of state income tax paid, which results in an additional deduction of $8,000 when compared to the deduction he would receive if the partnership were to forgo making the election. Assuming a federal tax rate of 24%, this additional $8,000 deduction represents a $1,920 federal tax savings to the taxpayer. As noted above, the taxpayer also will input a $13,000 payment towards his Idaho tax liability on his individual state tax return for the taxes his partnership paid at the entity level.

Although at first blush this workaround may seem to only be advantageous for taxpayers who itemize their deductions on their personal tax return, even those who fail to reach the amount of deductions necessary to itemize can benefit from making the election for entity level taxation. If a taxpayer doesn’t itemize on their return, any state income taxes paid do not produce a federal deduction. Upon making the election for entity level taxation, any state income taxes paid at the entity level reduce the taxpayer’s taxable income, which, in turn, reduces the taxpayer’s ending federal tax liability. The election essentially awards the taxpayer with the deduction for state taxes paid on their federal return, which would have been lost due to the taxpayer failing to reach the required amount of deductions to itemize.

Due to this workaround being limited to partnerships and S-corporations, taxpayers that are operating businesses that are taxed as sole-proprietors reporting directly on their individual tax return may want to consider changing their tax status to benefit from this workaround.

House Bill 317 is a major boon for Idaho pass-through entity members, but there are certain considerations that should be made before making the election. If you have any further questions or inquiries please feel free to reach out to any of our tax professionals.

Aaron Lavarias, CPA, Tax Manager