Under recently enacted Oregon legislation, certain partnerships and S corporations may elect to pay an “alternative business income tax” at the entity level. Or Laws 2021, ch 589 (SB 727). If they do so, these entities may provide an opportunity for their individual partners and shareholders to effectively deduct, on their federal income returns, Oregon income taxes attributable to partnership and S corporation income, notwithstanding the $10,000 federal individual income tax limit on the deduction of state and local taxes (the SALT-deduction limit). The law is generally effective for tax years beginning on or after January 1, 2022, and before January 1, 2024.
Although individuals may deduct a maximum of $10,000 of state and local taxes on their federal income tax returns, this limitation does not apply to entities. By permitting eligible partnerships and S corporations to move the incidence of state income tax on partnership and S corporation income to the entity level from the individual partner/shareholder level, the new legislation is designed to take advantage of this difference in federal income tax treatment.
Partnerships and S corporations, comprised solely (i) of individuals or (ii) pass-through entities which are owned entirely by individuals, may make the election to pay the alternative tax.
The tax is imposed on the aggregate sum of the members’ shares of distributive proceeds from the entity for that tax year. The tax is imposed at a rate of nine percent (9%) on the first $250,000 of aggregate member distributive proceeds and at a rate of nine and nine-tenths percent (9.9%) on aggregate member distributive proceeds in excess of $250,000.
How the Election Works
Partners and S corporation shareholders (collectively referred to as members) generally report their distributive shares of partnership or S corporation income and pay federal and state income tax on that income on their individual tax returns. As a result, the state and local taxes paid on that income is subject, together with all other state and local taxes the members pay, to the $10,000 federal SALT deduction limit. However, in computing a member’s distributive share of entity income for federal income tax purposes, a partnership or S corporation may deduct tax imposed and paid at the entity level.
The Internal Revenue Service (IRS) has stated that it intends to issue proposed regulations, which will provide that state and local income tax payments made by partnerships and S corporations, to satisfy state or local income tax liability imposed directly on the entity, are not subject to the SALT-deduction limit and may be deducted in computing members’ distributive shares of entity income. IRS Notice 2020-75.
Thus, if an entity makes the election to pay Oregon entity-level tax, that tax would be deducted in computing the members’ distributive shares of entity income on their federal Schedule K-1s.
In computing Oregon taxable income reported on their members’ Oregon Schedule K-1s, the entities are required to add back the Oregon alternative tax that had been deducted for federal income tax purposes. However, each member would be entitled to an Oregon income tax credit equal to the member’s pro-rata share of the Oregon alternative tax paid by the entity.
Key Limitations and Open Issues
- The Election May Not Benefit All Members: Due to the methodology used to compute the entity-level tax and the member tax credit, and differences in the individual members’ own tax situations, the election may not result in a reduction in members’ overall tax burdens. Under certain circumstances, it could increase their tax.
- Disregarded Entities: The SALT-deduction workaround does not apply to an entity, which is disregarded for income tax purposes as separate from its owner. An example is an LLC with a single member, where the LLC has not elected to be taxed as a corporation.
- Grantor Trust Member: It is unclear if a partnership or an S corporation with a member that is a grantor trust can elect to use the workaround. Because federal and Oregon tax law treat the grantor of a grantor trust as owning the assets of the trust, the grantor, and not the grantor trust, likely would be treated as the member for purposes of Oregon’s workaround. We hope that the Oregon Department of Revenue will provide guidance on this issue.
- Non-Grantor Trust Member: Given the narrow scope of entities that would qualify to make the election, it does not appear that a partnership or an S corporation with a non-grantor trust as a member would be eligible. The Department may provide guidance on this issue.
- Corporate or Tax-Exempt Member: A partnership or an S corporation with a member that is a C corporation or a tax-exempt entity cannot elect to use the workaround.
- No IRS Ruling: The Oregon workaround statute was just enacted. The IRS has not ruled on whether the statute complies with the requirements of IRS Notice 2020-75.
Repeal Before 2024
In the event Congress repeals the federal SALT-deduction limit, the Oregon workaround is repealed for any tax year to which the federal SALT-deduction limit is not applicable.