January 08, 2018
With the enactment of federal tax reform, otherwise known as the Tax Cuts and Jobs Act, there are a number of New Jersey state tax ramifications to consider stemming from the changes, including:
- the deduction for state and local taxes (“SALT”) paid by individuals;
- the limitation on the net operating loss deduction as applied to corporations; and
- the dividends-received deduction.
There are also a number of policy and tax filing options New Jersey and its taxpayers can consider in response.
The SALT Deduction Cap
Until 2018, individual and business taxpayers alike had the opportunity to deduct state and local income and property taxes from their federal taxable income. The Tax Cuts and Jobs Act, however, imposes a cap on the deduction for individual taxpayers in the amount of $10,000. This limitation, however, does not apply to business tax payments made in the production of income. Obviously, this change has significant ramifications for taxpayers in high income and property tax states, such as New Jersey.
There are a couple of different options the new Governor and Legislature can consider in response to the cap on the SALT deduction. Legislators and advocates are already calling for the state to increase the current $10,000 deduction available in the Gross Income Tax for property taxes paid. Another potential avenue for policy makers to consider is to allow charitable contributions to quasi-public entities in the state and provide a state tax credit for said contributions. Under this scenario, the taxpayer would realize a benefit at the state level in the amount of the tax credit generated, while also realizing a federal benefit equal to the amount of the contribution multiplied by the taxpayer’s marginal tax rate. The state could even allow employers and wage withholding agents to divert the funds directly from employee pay checks for ease of administration.
A second proposal could entail a major change to the gross income tax and employer withholding regime. Under current law, any employer with a place of business in the state or one that transacts business in the state that pays wages to New Jersey residents (or nonresidents for work performed in New Jersey) must make gross income tax withholding payments to and file reports with the Division of Taxation. The Governor and Legislature could potentially opt to overhaul this regime and instead, impose a payroll tax on these employers equal to the amount of gross income tax withholdings that would be due.
Under this approach, the employer would have the ability to reduce the employee’s net compensation based on the amount of payroll tax paid to the state. This would allow for the employer to take a deduction at the federal level equal to the amount of state income tax that would have been due from employees. In addition, the employees will no longer have to be concerned with their state income tax payments and whether a deduction will be received for federal income tax purposes. This would also ensure the $10,000 revised SALT deduction would be available for property taxes.
Finally, there is another avenue to consider for nonresident partners or limited liability company (LLCs) members—entity-level deductions at the federal level for payment of New Jersey tax on behalf of nonresidents. Even more interesting is the notion that New Jersey statute and regulations support this conclusion based on the structure of the tax.
Most states have something referred to as nonresident withholding, which essentially is a way for states to either (i) force nonresident partners/members to file for income tax on income derived from activities in the state, or (ii) simply collect the tax from the pass-through entity on behalf of the nonresident partners/members.
New Jersey’s withholding structure for partnerships and LLCs is a bit unique in that it is contained in the Corporation Business Tax (CBT) code and is considered a mandatory tax imposed on the partnership or LLC, regardless of whether or not the nonresident partners/members file in New Jersey. If the partnership or LLC has a nonresident individual partner or corporate partner with no place of business in the state, it must pay the tax. The tax due is equal to 6.37 percent for income allocated to nonresident individuals and 9 percent for income allocated to partners/members that are partnerships or LLCs themselves or partners/members that are corporations without a regular place of business in the state.
Furthermore, the CBT code even defines a taxpayer to include a partnership or LLC that must make payment on behalf of nonresident partners or members. In fact, the New Jersey Division of Taxation regularly assesses the tax against partnerships and LLCs in audits with corresponding penalties and interest.
In light of this unique tax structure, a colorable claim can be advanced that the partnership or LLC making the payment should be entitled to an uncapped SALT deduction at the federal level based on New Jersey’s statutes and regulations, because after all—New Jersey has explicitly sought to tax the business entity in these situations. And the new federal tax law continues the practice of an uncapped SALT deduction for business entity tax payments.
Limitation on Net Operating Loss Deduction for Corporations
Under the new federal tax law, corporations will be limited in the amount of a net operating loss (NOL) deduction that can be taken equal to 80 percent of the corporation’s taxable income without regard to an NOL deduction. Accordingly, if a corporation is profitable and reports net income, the minimum amount of tax that it would pay should be 4.2 percent of taxable income. (20 percent multiplied by the new applicable corporate tax rate of 21 percent.)
To increase revenues, it would not be surprising if New Jersey follows suit on some sort of NOL limitation. There is already precedent for such a policy change in the state dating back to 2002. For New Jersey corporate income tax purposes, NOL carry forward deductions were completely suspended in 2002 and 2003, while subject to a 50 percent taxable income limitation in 2004 and 2005. These measures were adopted at the time to address revenue shortfalls and economic downturn.
If the state decides to go down this path, the Legislature must be prepared to extend the life of NOL carry forward deductions that could not be used during a proposed suspension period. In addition, there may be additional complexities in calculating state tax basis in assets which are sold following the suspension period to account for the lack of a New Jersey tax benefit or loss. These resulting adjustments arising from a proposed NOL suspension have their own complexities and will need to be reconciled with federal income tax rules, but the state could easily go down the path of an NOL suspension or limitation that is similar to the new rule in the federal legislation.
Finally, the federal legislation significantly amends the dividends-received deduction (DRD) found in the Internal Revenue Code. Ordinarily, when a subsidiary issues or distributes a dividend to a parent company, that parent company is entitled to a deduction for the amount of dividends received to avoid double-tax at the corporate income tax level. Prior to 2018, a corporate taxpayer received a full deduction for dividends received from an entity which the taxpayer owns an interest in that is equal to or greater than 80 percent. There is an 80 percent deduction for dividends received from a subsidiary that is less than 80 percent owned, but 20 percent or greater owned by the recipient and a 70 percent deduction for dividends received from subsidiaries that are less than 20 percent owned by the receiving taxpayer.
The new tax bill reduces the 70 and 80 percent DRDs to 65 and 50 percent. Additionally, the new tax law provides for a 100 percent DRD for foreign-source dividends received from a foreign corporation by a corporate taxpayer that owns a 10 percent or greater interest in the payor. The DRD is not available for dividends that are deductible by the payor in computing its own taxes.
The New Jersey CBT also provides for a DRD equal to 100 percent of dividends received from subsidiaries which are at least 80 percent owned by the recipient and 50 percent of dividends from subsidiaries which are at least 50 percent owned by the receiving taxpayer. If there is less than 50 percent ownership, there is no DRD for state corporate income tax purposes.
In response to the federal changes, the state could further reduce or limit the DRD currently available. In the alternative, the state could consider conforming with the new federal regime.
There is another problem to consider here. The current DRD could pose a potential constitutional issue related to the new 100 percent DRD for foreign-source dividends. Since New Jersey requires a minimum ownership percentage of 50 percent for any form of a DRD, there will most likely be federal income taxpayers receiving these dividends that own less than 50 percent in the paying entities. Accordingly, this foreign source income could enter the New Jersey corporate income tax base, even though excluded from taxable income for federal income tax purposes. Making matters worse, New Jersey requires any NOL carry forward deductions to be utilized prior to the DRD.
The inclusion in the tax base (or utilization of NOLs) by foreign income that is derived from separate and distinct activities from those of the taxpayer is a constitutional problem for New Jersey based on the Commerce Clause. Additionally, the discrimination and disparate treatment from federal income tax law could run afoul of the Foreign Commerce Clause too.
Perhaps, this last point is a strong argument in favor of simply adopting the new federal provisions. Regardless of what policy makers decide in Trenton, one thing is for sure: we can expect to see even more changes in New Jersey SALT in 2018.