Rhode Island Entity-Level Tax Proposal Raises Legal and Practical Concerns

Since enactment of the Tax Cuts and Jobs Act (TCJA), states have employed strategies to work around the federal cap of $10,000 when deducting state and local income taxes (SALT) from one’s federal tax return. In addition to workarounds involving state charitable deductions and payroll taxes, several states have enacted a tax on pass-through businesses (such as S corporations and partnerships) to avoid the SALT deduction cap. Under recently-introduced legislation, Rhode Island looks to join their ranks.

State income tax codes typically allocate business income from pass-through firms on to the owners’ individual income tax returns. An entity-level tax assesses a liability directly on the firm before the income passes to the owners, much like a corporate income tax. States provide a credit for some or all of the entity-level tax paid for owners’ individual income tax liability. Because the TCJA only capped the deduction for SALT on individuals, not businesses, owners can only fully deduct SALT from their tax liability at the business level. 

Under H. 5576, Rhode Island pass-through businesses would have the option to pay an entity-level tax at the flat rate of 5.99 percent, with a state tax credit in that amount available to the owners on a pro rata basis. Because 5.99 percent is the top rate on Rhode Island’s individual income tax, with lower rates on income below $145,600, the appeal of this provision for taxpayers will vary based on the amount of business income they have, as well as how much taxable income they may earn from other sources.

Similarly, in 2018, Connecticut lawmakers established the pass-through entity tax (PET), which is assessed on partnerships and S corporations. This establishes a 6.99 percent tax on the pass-through firms at the entity level. On the individual’s income tax return, the PET provides credit for 93.01 percent of the pass-through entity tax paid. This tax works in a similar way to a proposed entity-level tax in New York, and a pass-through tax has been enacted in Wisconsin.

Rhode Island’s entity-level tax is voluntary, meaning that businesses for which it is a nuisance or would yield a tax increase need not adopt it. For some, it could mean a substantial reduction in tax liability. For others, it may not be so simple. While states tend to offer credits for taxes paid to other states (to avoid double taxation), the credits are tied to income taxes and are unlikely to apply to taxes recharacterized as entity-level payments.

If one or more of the business partners reside out-of-state, the lack of a credit for taxes paid to other states is only the beginning of their concerns. Those partners may have little or no income tax liability in Rhode Island itself, and their own state won’t offer them a tax credit for entity-level taxes paid. There is no mechanism for the entity-level tax to only be paid on the pro rata amount associated with in-state partners, or only distributed to them.

The American Institute of Certified Public Accountants has also highlighted another challenge to this arrangement: the Internal Revenue Service (IRS) may argue that any reliance on a state tax provision enacted to avoid the SALT limitation is a “listed transaction,” which requires taxpayers to disclose the transactions on federal income tax returns. Listed transactions are determined by the IRS to be methods to legally avoid tax. While this would not change the legality of the tax, it could be a source of complexity for taxpayers.

In September, the Treasury Department and IRS provided guidance on business expense deduction, clarifying that businesses can still deduct business-related taxes in full as a business expense on their federal income tax returns. This may bolster the case that entity-level taxes on pass-through firms comply with the TCJA and IRS rules.

But significant concerns remain. Professor Daniel Hemel of the University of Chicago Law School, who has defended the viability of New York’s other SALT cap workarounds (conclusions with which we have disagreed), has questioned whether the entity-level tax approach would succeed. Certainly, business taxes are fully deductible, but the Internal Revenue Code regards all income from pass-through businesses to be subject to the individual income tax and imposes the $10,000 cap on all “state and local, and foreign, income, war profits, and excess profits taxes,” among other taxes.

Professor Hemel maintains that the entity-level tax is still an income tax, and that the deduction flows through Schedule K-1 (for the business) to the individual owner’s 1040 and is claimed there. This means that a pass-through business does not have the ability to deduct the tax at the entity level because the federal code does not countenance entity-level taxation of such businesses. For federal purposes, it’s all individual income. If this interpretation is correct, it would defeat the entire purpose of such workarounds—in Rhode Island, Connecticut, Wisconsin, or anywhere else.

The IRS could also challenge entity-level pass-through taxes on quid pro quo grounds or argue that they differ from payment of individual income taxes in form only. Indeed, Scott Dinwiddie of the IRS’s Income Tax and Accounting Division recently said that regulations on the matter were “likely,” adding, “From the IRS perspective, the workarounds certainly have not gone unnoticed.”

Whether entity-level pass-through taxes pass legal muster, the benefit they provide to states and their highly-compensated taxpayers is not worth the added complexity and administrative costs, nor is there much equity in a provision which reduces taxes on the income of business owners but not their employees. States would be better off using their creative energy to refom their tax codes and alleviate the overall burden on taxpayers.