By: Ron Dean, CPA/MST, Director of Tax Services
On July 5th, 2019, Governor Raimondo signed the nearly $10 billion fiscal 2020 budget for the State of Rhode Island. There are many noteworthy provisions in the budget but, from a tax perspective, none more significant than the new “elective” pass-through entity-level tax. With this provision, Rhode Island joins a growing list of states trying to combat the $10,000 cap on an individual’s state and local income tax (SALT) deduction implemented under the Tax Cuts and Jobs Act.
Rhode Island Entity Level Tax Summary
For tax years beginning on or after January 1, 2019, a pass-through entity may elect, on an annual basis, to pay Rhode Island tax on net business income, at a rate of 5.99%, at the entity level. The owner(s) of the pass-through entity would still report their share of the net business income on their return, including an additional modification equal to the tax, but they would receive a credit for their share of the amount of tax paid by the pass-through entity. For this provision a pass-through entity is defined as one of the following:
Corporations that for the applicable tax year are treated as an S Corporation
Partnerships (General, Limited or Limited Liability)
Limited Liability Companies
Unincorporated sole proprietorships (which are not taxed as a corporation)
As a result of this being an entity level tax, Rhode Island is presuming that this tax will be allowed as a deduction on the Federal return of one the above-mentioned pass-through entities and would not be subject to the $10,000 SALT cap that applies to individuals.
Tax Planning Considerations
Careful consideration will need to be made when making this annual election because Rhode Island has a progressive tax system, which means as income rises, increasingly higher taxes are imposed. For the 2019 tax year, the Rhode Island (RI) tax brackets, for individuals, is as follows:
3.75% on the first $64,050 of taxable income;
4.75% on taxable income between $64,050 and $145,600; and
5.99% on taxable income over $145,600
The most likely scenario in which the annual election may not be advantageous is in a situation where a taxpayer has the ability to fully deduct SALT on their individual return and their RI taxable income is under $145,600. This could occur with a taxpayer who is the owner of multiple pass-through entities where one entity has a significant loss to offset income from another. In this scenario, if the taxpayer were to make the election on the entity that reports business income, the entity would pay tax at a rate of 5.99% and the taxpayer would receive a credit for their share of the amount of tax paid by the entity. As a result of the taxpayer’s RI taxable income being less than $145,600, their total income is taxed at a rate lower than 5.99%. Therefore, the taxpayer would have to wait until they file their individual return to receive a refund. If the taxpayer extends the filing of their individual return this could mean they have to wait up to 6 months before receiving the excess tax paid.
For taxpayers that plan to be in excess of RI’s highest income tax bracket, the election makes a lot of sense. In fact, one planning consideration would be to reduce the compensation of an S Corporation shareholder (while making sure not to violate the IRS reasonable compensation rules). By reducing the shareholder’s compensation, the S Corporation would increase its business income and the shareholder would report less W-2 wages. The total income reported by the S Corporation shareholder would be roughly the same but by increasing the income at the S Corporation level, and making the Rhode Island entity-level tax election, it would potentially allow for a state income tax deduction against the S Corporation’s business income that the shareholder would likely not be able to utilize due to the $10,000 SALT cap.
For pass-through entities that have Rhode Island nonresident owners, the State requires that the entity withhold the nonresident’s share of tax at the entity level. However, this is not deductible for Federal purposes. If the entity makes the annual election, then the nonresident withholding requirement is no longer applicable.
Another observation with regards to nonresidents is the potential credit they receive on their resident state tax return for taxes paid to other states. Typically, a taxpayer's resident state will tax all the income of a resident, regardless of where it is earned, and they will provide the resident a credit for taxes paid to the nonresident state on double taxed income. Will making this election prevent nonresidents from claiming a credit for taxes paid to Rhode Island due to it not being an income tax? These types of decisions are usually made on a state by state basis but Rhode Island has indicated that it will provide residents a credit for taxes paid to another state if that state has a similar type of entity level tax.
Often, tax professionals preparing entity returns may not prepare the individual return of all the owners. Therefore, an election decision might have to be made that is advantageous for some owners but not for all. The entity’s operating agreement may need to be amended to include provisions on how this entity-level tax election will be treated and if this is a decision for the partnership representative on an annual basis.
It remains a question whether this entity level tax will be allowed as a Federal deduction. Recently, the IRS issued Notice 2019-12, which effectively disallowed a similar workaround where states set up charitable funds to which taxpayers can contribute and receive a tax credit in exchange. It remains to be seen if this specific entity level tax workaround will be challenged, but other states including Connecticut, Louisiana, Oklahoma, and Wisconsin have recently enacted a similar entity-level tax.
As always, we will keep you posted on any new developments with the entity level tax. If you have any questions or would like to discuss how this impacts your particular situation, please feel free to reach out to one of our tax specialists at Restivo Monacelli LLP.
By: Ron Dean, CPA/MST, Director of Tax Services at Restivo Monacelli, an innovative tax, accounting and business advisory firm with offices in Providence, RI and Boca Raton, FL. As a Certified Public Accountant (CPA) with nearly a decade of experience, Ron leads the firm's prominent tax practice and provides creative tax strategies that ensure compliance, minimize tax burdens and protect clients' income.
In addition to his client-facing role, Ron oversees a team of managers, supervisors, senior and staff accountants, playing a significant role in their training and development. Ron and his team leverage their depth of expertise to deliver forward-thinking tax strategies and solutions to the firm's growing client base.
After earning his B.S. in Accounting from one of the New England's most renowned business schools, Ron launched his career at Restivo Monacelli as a Staff Accountant in 2008 and steadily climbed the ranks to his current position by taking advantage of the firm's numerous growth and development opportunities.