Prior to 2018, a taxpayer could generally deduct his state and local taxes for purposes of determining his federal taxable income. Beginning in 2018, the Tax Cuts and Jobs Act (P.L. 97-115) significantly changed these rules by generally limiting an individual’s state and local tax deduction to $10,000 per year. Since the enactment of this rule, states with high income tax rates have been considering various ways to work around this limitation. With regard to taxpayers that are partners in a partnership or shareholders in an S corporation, many states had considered allowing partnerships and S corporations to elect to be taxed at the entity level, with the partners or shareholders being allowed a credit for these entity-level taxes, such that the total state taxes paid would generally be the same as if the election had not been made.
It was hoped that these entity-level taxes would be deductible at the entity level for federal income tax purposes and that the partners or shareholders would be subject to federal tax only on the entity’s after-tax income, thus avoiding the $10,000 limitation with respect to the state or local taxes imposed on the partnership or S corporation.