When the Tax Cuts and Job Act (TCJA) was adopted in 2017, it presented financial challenges for certain business owners who are taxed as so-called Pass-Through Entities (PTEs). This is because the TCJA specifically limited a tax deduction for State and Local Income Taxes (SALT), essentially eliminating a federal tax deduction for state taxes on the profits of the business.
To help impacted business owners avoid this critical tax situation, the New Jersey Society of CPAs, with guidance and insights from Alan Sobel, Managing Member of SobelCo, developed an original concept – an innovative solution called Business Alternative Income Tax (BAIT).
The BAIT solution is straightforward: a PTE makes an annual election to be taxed under the entity level regime, and then taxes are paid on the income of the PTE by the PTE. The owners of the business subsequently receive a refundable credit to apply against their personal taxes computed on the same income, which also eliminates the concern over double taxation.
However, in implementing the initial legislation, certain interpretations by the New Jersey Division of Taxation were not consistent with the legislative intent of the original legislation. To rectify this, a “Clean Up Bill” was drafted and introduced to both houses of the New Jersey Legislature. This Clean Up Bill was passed unanimously by both Houses and signed by the Governor into law on January 18, 2022.
The legislation (S-4068), which is effective as of January 1, 2022, addresses five areas of BAIT that were in need of clarification:
The legislation clarifies that New Jersey Source income will be the basis for calculating the BAIT, as opposed to federal taxable income. In addition, the legislation permits a three-factor formula for allocation of income to New Jersey for all PTEs, thereby increasing the likely benefit to New Jersey resident business owners. The legislation further clarifies that tax payments made in tiered partnership structures can be applied to upper tier non-individual entities.
This will accomplish two important ‘traps’ in the original legislation: (1) The double payment of tax from a cash flow point of view until refunds can by paid by the State and (2) It clarifies that any BAIT payment credits that flow through to a “Sub S” Corporation will not be trapped in the “S” Corp and are now refundable. The legislation also eliminates the need for non-resident withholding on partner income, where the taxpayer has a reasonable basis that the BAIT would substantially cover the withholding amount required under separate provisions of New Jersey tax law.
The legislation codifies that overpayment of BAIT taxes by a PTE can be applied to future estimated taxes or if preferred, refunded. In the initial adoption, the overpayment had to be refunded.
The Clean Up Bill expands the highest tax bracket to include distributable income in excess of $1,000,000. This allows the BAIT to more closely align to the tax brackets of the Gross Income Tax, further helping business owners benefit from the legislation.
While the New Jersey BAIT is an imperfect solution to the overall SALT limitation issues brought about by TCJA, it does bring substantial relief to business owners in the Garden State. In the first fiscal year of adoption, the state Treasury collected approximately $2.1 billion – saving business owners an estimated $500 million. And with another nineteen states adopting similar legislation (with more states to follow), New Jersey can stand tall in leading the charge of helping small and mid-sized businesses.
If your business is a Pass-Through Entity (PTE), you should consult with your SobelCo tax advisor to ensure you are leveraging this tax savings technique to save your business substantial money.
