Who is going to voluntarily sign up for a tax increase? Massachusetts is betting that a lot of business owners will – which is why they’ve put an option to do so into their budget for fiscal year 2022 – spoiler alert: it’s good for them (obviously), good for you (if you file an 1120S or 1065), and the Feds lose on this one (for the rest of us not on a governments fiscal calendar this will impact the filing of 2021 income taxes).
Prior to the Tax Cuts and Jobs Act of 2017 (the Act) many taxpayers were able to take deductions against their federal taxable income for the income taxes paid to state and local governments, as well as real estate taxes paid on personally used real estate, e.g. primary home and “Cape House” (real estate held for investment/rental is different). Collectively these are referred to as SALT – State and Local Taxes. Well, the Act, amongst other things, some good and some bad, limited this deduction to a maximum of $10,000 – this was a severe restriction for many, particularly those in high tax states (primarily those on Coasts). Many states have put in place workarounds, and as of July 16, 2021, so has Massachusetts.
Owners, Shareholders, Members, and Partners of S-Corporations (form 1120-S) and Partnerships (form 1065) will have the ability to elect to pay an excise tax on qualified income taxable in Massachusetts at a rate of 5% (same as the Massachusetts individual income tax rate). However, the new law provides for the issuance of a refundable credit to shareholders and partners equal to 90% of their share of the new excise tax.
So, who in their right mind would sign up to pay more taxes to get a lesser credit back? … sit back and watch the math work!
* For Singles this is from $86,000 to $165,000 and MFJ $173,000 to $330,000 (approx).
A few quick observations:
- This illustration/ calculation is brutally simple – and not the way a tax return works – but the math works, and it gets the point across.
- You don’t necessarily have to do anything extra to get this deduction (although planning is and will be critical).
- The more you make, i.e. the higher your federal tax rate, the more impactful this becomes.
- It effectively lowers your federal top-line income, therefore other phase outs and limitations that you may be subject to could be impacted here as well (in a positive way).
Did somebody say planning? Our second favorite sport, after Ping-Pong. A lot is going to go into this. Tons of planning needs to occur – from strategies to where and how revenue is recognized, to entity selection, to ownership considerations, to the type and timing of revenue recognition, to the math to figure out the tax rate arbitrage at play. A few examples/ considerations:
- Rental real estate that produces a significant profit is owned by one spouse only, and therefore reported on Schedule E, simple enough… but this income can’t apply. Should you gift a portion to your spouse? Which would then require a form 1065 and trigger the ability to get at this deduction.
- You operate a profitable business as a single member LLC and therefore report on Schedule C, simple enough… but this income can’t apply. Should you consider making a late S-election? Which would then require a form 1120S and trigger the ability to get at this deduction.
- Your operating business pays rent to your real estate trust. The income reported in the trust is not able to get at this deduction, should you revisit your lease?
- You’ve been paying yourself a large salary to enable heavy retirement funding – maybe there is way to lower the salary subjecting more income to this deduction and still achieve your retirement funding goals.
None of these scenarios, or your particular situation, can be addressed in a silo unto itself. Proper planning is comprehensive and incorporates all the other tax, estate, legal, and legacy issues that surely come up. This is sure to be a great tool in our toolbox, and one that should be at least considered and explored by pretty much everyone who generates income from a business or a rental property.