Here's the gist of how the new law is supposed to work:
1) NJ will start implementing a new business tax, effective January 1, 2018, on pass through business entities (such as limited liability companies, S-Corporations, and Partnerships).
2) This new business tax will be roughly equal to the tax the owners of the business are already paying on their NJ income tax returns.
3) The owners of the business will receive a dollar for dollar credit on their personal NJ income tax returns for any business taxes paid.
The legislature was effectively trying to make this a wash from a NJ revenue standpoint, but let's be clear, this will raise significant revenue for New Jersey because the tax rates don't align perfectly with the income tax rates for either individuals or married couples.
For example, under the new business tax law, there is a:
1) 5.525% tax on the distributive proceeds less than $250,000 (per owner);
2) 6.37% tax on distributive proceeds between $250,000 and $1M (per owner);
3) 8.97% tax on distributive proceeds between $1M and $3M (per owner); and
4) 10.75% tax on distributive proceeds over $3M.
For a single person, the NJ income tax rates are as follows:
| NJ Tax Bracket - Single Person | NJ Tax Rate |
|---|---|
| $0.00 - $19,999 | 1.4% |
| $20,000.00 - $34,999 | 1.75% |
| $35,000.00 - $39,999 | 3.5% |
| $40,000.00 - $74,999 | 5.53% |
| $75,000.00 - $499,999 | 6.37% |
| $500,000.00 - $4,999,999 | 8.97% |
| $5,000,000 + | 10.75% |
| NJ Tax Bracket - Married Couple | NJ Tax Rate |
|---|---|
| $0 - $19,999 | 1.4% |
| $20,000 - $49,999 | 1.75% |
| $50,000 - $69,999 | 2.45% |
| $70,000 - $79,999 | 3.5% |
| $80,000 - $149,999 | 5.53% |
| $150,000 - $499,999 | 6.37% |
| $500,000 - $4,999,999 | 8.97% |
| $5,000,000.00 + | 10.75% |
However, if this new law goes into effect, it will be a significant net savings for NJ business owners because they will not be as badly impacted by the new federal law. Remember, the Tax Cuts and Jobs Act signed by President Trump stated that State income taxes and local property taxes are capped at $10,000 per year. The reason that NJ business owners will not be adversely affected by this new (and usually higher) business tax is that NJ is converting a non-deductible state income tax (from your personal return) into a deductible business expense.
Let's run through an example. Let's say that Joanne owns a nearby estate planning law firm structured as a limited liability company. Joanne's net income after all expenses (except state income taxes) is $150,000. (For purposes of this example, let's assume that she is single and has no other income and is not entitled to any other deductions other than a $10,000 property tax deduction for her primary residence.)
If the New Jersey Pass-Through Business Alternative Income Tax Act does not come into law, then she would have a state income tax liability of approximately $7,365 and a federal income tax liability of $19,533 (after factoring in the 199A deduction of 20% and the $10,000 property tax deduction). Total tax liability of approximately $26,898. Joanne does not get to deduct the $7,365 from her federal income taxes.
If the New Jersey Pass-Through Business Alternative Income Tax Act does come into law, then there would be a NJ business tax of $7,875, no NJ personal income tax, and a federal income tax liability of approximately $18,118 after reducing the $150,000 of income by $7,875 and then factoring in the 20% 199A deduction. Total tax liability of $25,993.
As you can see, the big difference is that the $7,875 should be considered a deductible business expense for purposes of the federal tax law. So even though there is an additional $510 of NJ state taxes, there is $1415 less of federal income taxes, for a total savings of $905.
If and when the NJ law actually passes, I will provide another update.
* Note - all calculations for taxes done using free software with minimal assumptions, so please do not rely on them. I am just trying to illustrate how the new tax law should work in theory.
