On Monday, December 20, 2021, Michigan Gov. Gretchen Whitmer signed into law House Bill 5376 (HB 5376), a bill that amended the Michigan Income Tax Act to allow pass-through entities such as S corporations, partnerships and certain trusts to make an election to pay tax at the entity level, and allow members/shareholders a credit for their portion of entity taxes paid. To understand the significance of this law, a little history is necessary.
Prior to the Tax Cuts and Jobs Act of 2017 (TC&JA), individual taxpayers had an unlimited federal tax itemized deduction for various taxes paid during the tax year, including state, local and foreign income taxes; state and local sales taxes; and state and local real estate and personal property taxes. For shareholders of S corporations and members of limited liability companies treated as partnerships for federal income tax purposes, income of these entities would be allocated to the shareholders/members, and they would then report such income on their individual federal tax returns and pay the necessary individual federal income taxes associated with such income. Shareholders/members would then deduct as an itemized deduction without limitation from their federal tax return the amount of state and local income taxes paid for the passthrough entities along with the other qualifying taxes paid. Generally, these passthrough entities would not pay income taxes at the federal level.
With the passage of the TC&JA, a $10,000 cap was placed on the federal itemized deduction for taxes paid by individuals, thereby increasing the tax burden for taxpayers with tax payments exceeding the cap. In response to this, a number of states sought legislation to offset the effect of this additional tax burden without negatively impacting state tax revenues. HB 5376 is Michigan’s response to the TC&JA cap limitation.
Under HB 5376, taxpayers who are shareholders or members of passthrough entities or certain trusts can elect to calculate and pay Michigan income tax at the entity level. The tax rate at the entity level is 4.25 percent, the same as the individual income tax rate. With an election in place and payment of the necessary taxes, the passthrough entity can then deduct the amount of taxes paid without limitation on their federal tax returns (e.g., Form 1120S for S corps, Form 1065 for partnerships). Shareholders/members of such passthrough entities can then claim a credit on their Michigan individual income tax returns for their share of Michigan income taxes paid at the entity level. If the credit exceeds tax, it can result in a refund. The State of Michigan essentially receives the same amount of income taxes with the election in place – just from a different party, the passthrough entity. Hence, the “workaround”.
The election can be made retroactively beginning with the 2021 tax year, but it must be made by April 15, 2022. Once made, it is irrevocable for two years. HB 5376 generally requires estimated tax payments for the passthrough entities, and can impose penalties and interest if not paid, but will not pursue such penalties and interest for the 2021 tax year if the tax is paid by April 15, 2022. Please note, however, that for cash basis taxpayer entities, payment must be made by December 31, 2021 to deduct such taxes on its federal passthrough tax return. The cap is currently slated to expire after 2025, but there is substantial discussion about potentially altering the timing of this.
With a significant amount of opposition to HB 5376 in Michigan as well as concerns by federal legislators facing the SALT workarounds, Varnum is continuing to monitor developments related to HB 5376. We also expect the State of Michigan to issue additional guidance with respect to the SALT workaround and will be reviewing all such guidance to provide up-to-the-minute guidance to our clients. Given the short-term deadlines and the complexity of the SALT workaround, we recommend that you contact us as soon as possible to determine whether this election is right for you and what actions are necessary to be timely.