Tax News Update    Email this document    Print this document  

November 13, 2020

IRS plans to issue proposed regulations on deductibility of certain state and local tax payments by partnerships and S corporations

The IRS has announced (Notice 2020-75) (Notice) that it will issue proposed regulations (Proposed Regulations) clarifying that a partnership or S corporation computing non-separately stated taxable income or loss may deduct state and local income taxes imposed on its net income for the tax year at issue.

According to the Notice, the forthcoming Proposed Regulations will apply to payments made on or after November 9, 2020, although taxpayers will be permitted to apply the rules described in the Notice to payments made in a partnership or S corporation tax year ending after December 31, 2017 and before November 9, 2020. The IRS further stated that taxpayers may rely on the Notice until the Proposed Regulations are issued.


Until enactment of the Tax Cuts and Jobs Act (P.L. 115-97) (TCJA), payments of state and local taxes (SALT) have been deductible under IRC Section 164(a) for the tax year in which they were paid or accrued, with some limitations. These SALT payments include taxes on real property, personal property, sales and use tax, and net income, among others. In particular, IRC Section 164 has specifically allowed for the deduction of SALT payments paid or accrued in carrying on a trade or business activity described in IRC Section 212.

A partnership's taxable income is generally computed (IRC Section 703(a)) in the same manner as an individual's taxable income, except that items described in IRC Section 702(a) must be separately stated and the partnership may not claim certain deductions. For instance, a partnership may not deduct tax payments under IRC Section 164(a) for taxes described in IRC Section 901 (i.e., taxes paid or accrued to foreign countries or to US territories). IRC Section 1363(b)(1) and (2) provides similar restrictions on the deductibility of SALT payments for S corporations.

Under IRC Section 702(a), a partner must take into account both the partner's separate distributive share of certain partnership items of income, gain, loss, deduction and credit, and non-separately computed income and loss. IRC Section 1366(a)(1) imposes parallel requirements on S corporation shareholders.

In December 2017, IRC Section 164(b)(6) was added by the TCJA. It effectively limits the SALT deduction for individuals to $10,000 ($5,000 for married individuals filing separately). This $10,000 cap on the SALT deduction applies, in part, to real property, personal property, income, and sales taxes for tax years beginning after December 31, 2017 and before January 1, 2026. Specifically, the SALT deduction cap does not apply to state and local taxes that are: (1) described in IRC Section 164(a)(3) and imposed by a foreign country; or (2) described in IRC Section 164(a)(1) and (2) and paid or incurred in carrying on a trade or business.

In enacting IRC Section 164(b)(6), Congress expressly stated that "taxes imposed at the entity level, such as a business tax imposed on pass-through entities, that are reflected in a partner's or S corporation shareholder's distributive or pro-rata share of income or loss on a Schedule K-1 (or similar form), will continue to reduce such partner's or shareholder's distributive or pro-rata share of income as under present law."

Some jurisdictions described in IRC Section 164(b)(2) (primarily states and cities) have enacted or considered enacting tax laws that impose a mandatory or elective entity-level tax on partnerships and S corporations that do business in the jurisdiction or have income derived from or in connection with sources within the jurisdiction, commonly referenced as "pass-through entity taxes" (PTE taxes). The Notice points out that the state or local tax law in certain jurisdictions "provides a corresponding or offsetting, owner-level tax benefit, such as a full or partial credit, deduction, or exclusion" for PTE taxes deducted at the entity level and that Treasury and the IRS "are aware that there is uncertainty as to whether entity-level payments made under these laws" to jurisdictions other than US territories must be taken into account in applying the $10,000 SALT deduction limit at the owner level.

Outline of the Proposed Regulations

In the Notice, the IRS stated that the forthcoming Proposed Regulations are needed to provide certainty to individual partners and S corporation shareholders in calculating their SALT deduction limitations. Accordingly, the Proposed Regulations will clarify that partnerships and S corporations may deduct "Specified Income Tax Payments" in computing their non-separately stated income or loss.

The Notice defines Specified Income Tax Payments as any amount that a partnership or S corporation pays to a state, a political subdivision of a state, or the District of Columbia (Domestic Jurisdiction) to satisfy an income tax liability imposed on the partnership or S corporation. Specified Income Tax Payments expressly do not include taxes imposed by US territories or their political subdivisions. The definition includes only income taxes described in IRC Section 164(b)(2) for which (1) a partnership may claim a deduction under IRC Section 703(a)(2)(B) and (2) an S corporation may claim a deduction under IRC Section 1363(b)(2). Therefore, a Specified Income Tax Payment includes any amount that a partnership or S corporation pays to a Domestic Jurisdiction under its ability to impose an income tax. This applies whether or not (1) the income tax liability results from an election the entity made; or (2) the partners or shareholders received a deduction or other tax benefit based on their share of what the partnership or S corporation paid to satisfy its liability.

The Proposed Regulations will permit a partnership or S corporation that makes a Specified Income Tax Payment during a tax year to claim a deduction for the payment in computing its taxable income for the tax year in which the payment is made.

Further, any Specified Income Tax Payment that a partnership or S corporation makes during a tax year will not constitute a deductible item that partners or S corporation shareholders may take into account separately under either IRC Section 702 or IRC Section 1366 in determining their federal income tax liability for the year. Rather, any Specified Income Tax Payment must be reflected in the partner's or S corporation shareholder's distributive or pro-rata share of non-separately stated income or loss reported on Schedule K-1.

Finally, any Specified Income Tax Payment that a partnership or S corporation makes may not be taken into account in applying the SALT deduction limit to any individual partner or S corporation shareholder.


The headline of the IRS news release (IR-2020-252) states that the Notice "provides certainty regarding the deductibility of payments by partnerships and S corporations for State and local income taxes." How helpful this certainty is, however, remains an open question. At first blush, this is a taxpayer victory and could be viewed as an implicit concession by the executive branch that it could not stop the states from enacting tax legislation that would enable federal taxpayers to work around the limitations in IRC Section 164(b)(6).

But, is there more? One could say this Notice favors business owners over their employees because the principles in the Notice subject individual taxpayers to disparate results based solely on whether they receive payments as owners or as employees. A business owner effectively is entitled to an unlimited deduction for state and local taxes paid at the entity level, while its employee's SALT deduction is capped at $10,000 ($5,000 if married filing separately) under IRC Section 164(b)(6). This result is not inconsistent with other provisions in TCJA, such as the special business deduction provided for owners of PTEs under IRC Section 199A. Nonetheless, this interpretation could be seen as contrary to legislative intent to treat owners and employees similarly — specifically, the intent of Congress in 1944 when it created the demarcation between above-the-line and below-the-line deductions by first creating the concept of "adjusted gross income" so that owners and employees would be treated similarly.

Although the Notice and the forthcoming Proposed Regulations would appear to resolve one issue, they certainly raise another — will a partner's or shareholder's state of residence, which is generally entitled to tax 100% of the taxpayer's income, allow that individual a credit for her share of the entity-level taxes paid to another state? Moreover, will states that haven't already enacted PTE taxes rush to do so in 2021, such that individual partners and shareholders will have a state tax profile more akin to a C corporation shareholder than a pass-through owner of the old days? (States that have enacted PTE taxes (or PTE tax elections) include Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island and Wisconsin.)

At this point, this very taxpayer-favorable Notice will likely be met with celebration and a flurry of state legislative activity in an attempt for states that do not already credit such a tax to benefit their citizens to quickly conform and provide similar benefits. The celebration could end, however, when one state doesn't extend its credit for taxes paid to other states to cover the resident partner's or shareholder's distributive share of the PTE taxes paid elsewhere but deducted for federal income tax purposes. In effect, individual partners and shareholders in some states would be trading a federal income tax deduction worth up to 37% of every dollar for an additional dollar-for-dollar of state tax paid to their home state for which no credit may be allowed.


Contact Information
For additional information concerning this Alert, please contact:
National Tax – Private Client Services
   • David Kirk (
State and Local Taxation Group
   • Steve Wlodychak (
   • Rebecca Bertothy (
Partnerships and Joint Ventures Group
   • Jeff Erickson (