This legislation imposes a new, elective entity-level tax on the income of partnerships and S-corporations, each of which are commonly referred to as “pass-through entities” for tax purposes. Prior to this legislation, the income of a pass-through entity was subject to the personal income tax of the owner in proportion to the ownership interest in the entity. In 2017, federal tax law reduced from an unlimited amount to $10,000 the amount an individual can claim as an itemized deduction for state and local taxes paid on an individual taxpayer’s annual tax return.
State and local income taxes are commonly referenced to for tax purposes as “SALT” taxes. This 2017 federal limitation on the itemized deduction for SALT taxes included state taxes paid on the income of a pass-through entity and, as a result, materially limited the federal tax benefit of state income taxes paid personally by an owner on the taxable income of a pass-through entity.
Consistent with guidance from the United States Department of the Treasury and the Internal Revenue Service as published in Internal Revenue Service Notice 2020-75, 2020-49 I.R.B. 1453, this legislation will enable the pass-through entity, rather than the owners of a pass-through entity, to take a federal tax deduction for SALT taxes elected to be paid by the pass-through entity. Accordingly, this legislation, conceptually similar to legislation enacted in more than 25 other states, will mitigate the new federal limitation on the personal itemized deduction for SALT taxes that otherwise would have been paid personally by an owner on the taxable income of a pass-through entity.
Generally, the approach undertaken by this legislation follows a two-step process. First, an eligible pass-through entity that elects to pay the new entity-level tax, computes and pays Delaware income tax on income taxable in the State, which income, in the absence of the election, would have been subject to Delaware income tax at the individual level for each member of the entity. All income tax elected to be paid by the pass-through entity is taxed at 8.7%. Second, the electing pass-through entity allocates modified income to its members in proportion to their ownership interest in the entity, for which allocation each member is entitled to a reduction from federal adjusted gross income for individual State income tax purposes.