Governor Murphy signed a clean-up bill for New Jersey’s Business Alternative Income Tax (BAIT) which will effectively reduce the tax burden many of the state’s businesses and owners have faced in recent years. The news is good for businesses which rely on pass-through entities (PTEs) such as partnerships, LLCs, and S-corporations, to make annual elections that alleviate the limitation on the deduction of state and local taxes (SALT). NJ BAIT offers businesses and their owners with income primarily sourced in the state a much-needed SALT Cap workaround that offsets the Federal $10,000 limit for all SALT (including income tax and real estate holdings) which was established by the Tax Cuts and Jobs Act (TCJA) of 2017. The NJ BAIT Act, which is effective for tax years beginning on or after January 1, 2020, affords passthrough entities operating in New Jersey the option of electing to pay the tax due on the owner’s share of distributive proceeds from the pass through entity. Distributive proceeds include the net income, dividends, royalties, interest, rents, guaranteed payments, and gains of a passthrough entity that is sourced to New Jersey.
A Brief History of the BAIT
As often happens with new legislation, the language used can leave room for various interpretations that were not intended by the drafting parties and further legislation must be created in order to clarify and make the guidance more explicit. Recognizing this issue, New Jersey lawmakers put forth the NJ BAIT clean-up bill which the governor has just signed.
Originally, the purpose of New Jersey’s passthrough entity BAIT was to give individual taxpayers in the state a tax benefit on their Federal return that would have otherwise been limited and less advantageous.
Effective for tax years beginning in 2018, the passage of the Tax Cuts and Jobs Act (TCJA) effectively capped the state and local tax (SALT) deduction at $10,000 for individual taxpayers. For example, in 2018 and 2019, a taxpayer paying $15,000 in property taxes on their New Jersey home and $20,000 in state income tax, would have been limited to an overall $10,000 SALT deduction on their individual tax return. Therefore, the taxpayer would have lost $25,000 in tax deductions that they would have enjoyed prior to TCJA.
In order to bypass this limitation which would have affected many middle-class Americans, states created the pass through entity tax. Essentially this tax allows pass through entities (PTEs) to calculate and pay the state tax that their members and partners would be subject to on the income allocated from the PTE. The passthrough entity then takes a deduction for the state’s taxes on the PTE’s Federal tax return and passes on the income to the members’ and shareholders’ net of the state taxes. For example, if a retail business operating in New Jersey and applying the BAIT has two partners who were allocated $1,000,000 each, then an electing partnership can pay the tax due on the owner’s share. Using a tax rate of 6.52% from the state-provided tax table, the tax would be approximately $65,000 for each partner. The partnership would then deduct the $65,000 tax from the $1,000,000 distributive proceeds and report $935,000 on the Federal K-1 of each partner. The partner, in effect, gets a $65,000 tax deduction in addition to the $10,000 state tax itemized deduction. The partner can then claim a credit for the PTE tax paid on his or her behalf on their New Jersey personal tax return and claim a refund for any excess PTE tax that cannot be utilized in the current year.
Many states have created similar passthrough entity tax legislation to New Jersey’s BAIT Act and the list continues to grow.
What’s Changing for NJ BAIT
The NJ BAIT Act just signed alters the tax calculation to make it more advantageous to businesses and their owners, ensuring that a greater portion of their income can be included in the calculation. Changes are effective for January 1, 2022. Most notably, the clean-up bill allows the BAIT to be applied to all income from a partnership rather than solely the New Jersey source portion as noted in the original legislation. The intention is that this change will result in the possibility of a more substantial tax credit for those who make the annual election. It also changes the structure of the tax credit and provides a pathway for more uses of these more taxpayer-friendly credits. The revision modifies the BAIT tax brackets so that they are in greater alignment with New Jersey’s current gross income tax brackets, under which the income is ultimately taxed. Finally, how tax overpayments are addressed and an abundance of tax credits are utilized has been changed by the new act so that both the overpayments and the excess credits can be applied to tax liability in future years.
For more information on New Jersey’s BAIT, contact your Untracht Early advisor.