Tax Update: IRS Provides Certainty Regarding the Deductibility of Payments by Partnerships and S Corporations for State and Local Income Taxes

IRS Notice 2020-75 (‘the Notice”) was issued on November 9, 2020 and announced that the Department of the Treasury and the Internal Revenue Service intend to issue Proposed Regulations to clarify that State and local income taxes imposed on and paid by a partnership or an S corporation on its income are allowed as a deduction by the partnership or S corporation in computing its non-separately stated taxable income or loss for the taxable year of payment. Furthermore, the Proposed Regulations will provide certainty to individual owners of partnerships and S corporations in calculating their state and local tax deduction payments.

Based on the statutory and administrative authorities described in Section 2 of the Notice, the forthcoming Proposed Regulations will clarify that “Specified Income Tax Payments” (as defined in section 3.02(1) of the Notice) are deductible by partnerships and S corporations in computing their non-separately stated income or loss.

“Specified Income Tax Payments” means any amount paid by a partnership or an S corporation to a State, a political subdivision of a State, or the District of Columbia (Domestic Jurisdiction) to satisfy its liability for income taxes imposed by the Domestic Jurisdiction on the partnership or the S corporation. The proposed regulations described in this Notice will apply to Specified Income Tax Payments made on or after November 9, 2020. The proposed regulations will also permit taxpayers to apply the rules described in this Notice to Specified Income Tax Payments made in a taxable year of the partnership or S corporation ending after December 31, 2017, and made before November 9, 2020, provided that the Specified Income Tax Payment is made to satisfy the liability for income tax imposed on the partnership or S corporation pursuant to a law enacted prior to November 9, 2020. Prior to the issuance of the Proposed Regulations, taxpayers may rely on the provisions of this Notice with respect to Specified Income Tax Payments.

The resulting impact of this Notice and the forthcoming Proposed Regulations is that many partners in partnerships and shareholders in S corporations, who have had payments made on their behalf to states other than their resident state, may be able to increase their state and local tax deduction related to their itemized deductions on their 2018 and 2019 Form 1040 resulting in potential federal refunds.

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