Should NJ Professional Services Firms Take the “BAIT?”
February 01, 2021
By Jeanne-Marie Waldman and William Gentilesco
In January 2020, New Jersey enacted the Pass-Through Business Alternative Income Tax (“BAIT”). This legislation generated only passing interest from the taxpaying community until the Internal Revenue Service’s (“IRS’s”) November release of Notice 2020-75 in which it expressed a favorable view toward state-sponsored pass-through entity (“PTE”) state and local tax (“SALT”) workarounds. Enticed by the potential for significant federal tax savings, professional service firms organized as PTEs want to know how they can benefit from the new law.
How Do Owners Benefit?
The BAIT enables owners of PTEs to reduce their federal taxable income by remitting this entity-level tax on its New Jersey-sourced income, thereby bypassing the SALT limit for individual owners who itemize deductions. As a result, partners and shareholders will report reduced federal income from the PTE, net of the BAIT. On their New Jersey returns, owners subject to NJ Gross Income Tax will be eligible to claim a refundable credit for their proportionate share of the BAIT liability for that year.
How Do Owners Participate?
Professional service firms taxed as S corporations (with a New Jersey S corporation election), partnerships and multi-member LLCs may elect into this entity-level tax as long as at least one member is liable for Gross Income Tax on its share of taxable PTE income. Firms organized as single-member LLCs or sole proprietors are ineligible for participation in this program.
New Jersey assesses the BAIT at graduated rates from 5.675% to 10.9%. An authorized member of a PTE must make the annual electronic election, due March 15 or before the 15th day of the third month following the close of the PTE’s fiscal year. Although the election is made at the entity level, it requires the consent of each member of the electing entity that is a member at the time the election is filed—or by any officer, manager or member of the electing entity who is authorized under the law or the entity’s organizational documents to make the election. An entity may also revoke its election during the same period, but cannot elect or revoke the BAIT election retroactively.
Which Owners Benefit?
In a perfect scenario, a profitable firm with only residents of New Jersey or states with no income tax (e.g., Florida, Texas) the BAIT is clearly beneficial and there are few, if any, drawbacks to making the election. If there are non-resident owners in states with their own personal income tax, the situation becomes more problematic.
The major concern—unknown as of this writing—is whether other states will allow their residents to claim a resident credit for NJ tax paid via the BAIT. Non-residents could be seriously disadvantaged if their home states disallow the credit for BAIT payments.
Quantitatively, the enhanced federal deduction of the tax is equal to the owner’s share of the BAIT multiplied by the owner’s marginal federal income tax rate. The credit, on the other hand, is a dollar-for-dollar benefit, so that non-residents would be at a serious disadvantage if their resident state reduced or disallowed the credit for taxes paid.
Consider this example illustrating the detriment to a non-resident partner whose state disallows the resident credit:
Let’s say that the partner’s share of the BAIT on New Jersey taxable income is $100,000. The value of that deduction on the federal return, assuming the maximum marginal rate of 37%, is worth $37,000, but the potential loss of the resident credit on the out-of-state partner’s tax return is the full $100,000. Therefore, the net potential cost to the non-resident owner of the firm’s BAIT election would be $63,000.
To date, there is negligible state guidance on how other states will treat the BAIT for credit purposes. Thus, firms with NJ non-resident partners should think carefully about the impact of the BAIT election. Complicating the analysis even further is whether the BAIT, an elective entity tax, will be recognized similar to a mandatory tax, such as the Connecticut PTE tax, for purposes of the resident credit. Commentators speculate that states with their own entity-level taxes will accept the BAIT for the resident credit, but there could be an intervening year (or years) where the credit is compromised. For example, if another state enacts a PTE tax in 2021, it may allow a credit for the BAIT starting in 2021, but deny or reduce the credit for 2020.
Regardless of its participation in the BAIT, a firm organized as a PTE must continue to withhold tax on the non-resident owners’ New Jersey income. Therefore, the BAIT may result in a significant overpayment1 of non-resident tax until the owners can file their individual tax returns to claim refunds, which could be as late as October of the following year. BAIT estimates are not due for 2020, but starting with the first quarter of 2021, firms are required to make quarterly payments. Depending on the magnitude of the NJ income, quarterly payments for both non-resident withholding and the BAIT may be a cash flow burden.
Non-equity partners or members who receive guaranteed payments but no distributive share will not benefit because the deduction reduces only ordinary income. Finally, firms with bank loans or other debt should consider whether an entity-level tax liability could have financial statement implications.
Whether or not a professional services firm should elect participation in the BAIT is a highly fact-dependent inquiry. Firms should consider this decision carefully, paying special attention to their resident state(s) and any recent legislative guidance about the credits. Between now and March 15, the deadline for the election, it is recommended that the firm’s management discuss the advantages and disadvantages of the BAIT with their tax advisors who will be monitoring state developments in this area.
1 The relative amounts of the two payments will vary based on a firm’s unique revenue stream. The BAIT apportions receipts using an evenly-weighted 3-factor formula, sourced according to the place of performance. For S Corporation taxable income and non-resident partnership withholding, receipts are apportioned using a single sales factor and market sourcing.