New Mexico Governor Michelle Lujan Grisham signed HB 102, creating an annual elective entity-level tax for New Mexico pass-through entities on March 8, 2022.

This election, first available for tax years beginning in 2022, allows certain pass-through entities, such as partnerships, limited liability companies (LLCs), and S corporations, to pay New Mexico state income tax at the entity level, rather than requiring each individual owner to pay tax on their share of the pass-through entity income.

Governor Lujan Grisham signed HB 368 on April 5, 2023, which enacted several changes to this election for tax years beginning in 2023 and beyond.

Background

The purpose of this election is to provide relief to small business owners who were negatively impacted by the 2017 federal Tax Cuts and Jobs Act, that limited the amount of state and local tax deductions that could be claimed on federal tax returns to $10,000.

By allowing a pass-through entity to pay state income tax at the entity level, rather than at the individual level, an entity is able claim a full deduction for state tax paid on its federal tax return.

Historically, the state tax due on an entity’s income would have been paid on the individual owners’ tax returns. In most cases, that state tax would not have been deductible on the owners’ federal returns due to the $10,000 cap.

Other Considerations Before Making the Election

It’s critical to understand the risks of possibly losing or reducing the benefit of other tax attributes, such as:

• The Internal Revenue Code (IRC) Section 199A deduction
• Trapping tax attributes, such as net operating losses at the entity level
• The separation—at different levels—of income and offsetting deductions, such as depletion, which is particularly important for oil and gas partnerships
• Losses from other investments

Additionally, not all pass-through entity owners will be in the top individual tax bracket; many will be in the 4.9% bracket. Consequently, it’s possible that in 2022, the election will result in more tax being paid than would be due if the election weren’t made. Given the complexities of pass-through entity elections, the impact should be modeled before the pass-through entity decides to elect.

Legislation for 2023 and Later

House Bill 368 provides multiple important changes to the New Mexico pass-through entity tax that will impact this election and provide several clarifying points.

These changes, applicable to tax years beginning on or after January 1, 2023, are as follows.

• An owner of an electing pass-through entity may receive a refundable credit in the amount of the owner’s share of tax paid by the pass-through entity. This contrasts with the 2022 treatment, which allowed for electing pass-through entity owners to exclude pass-through entity
• An entity making the election makes the election binding on all owners.
• Guaranteed payments are included in the tax calculation for partnerships.
• Removes income allocated to an upper tier-pass-through entity from the calculation of net income at the electing pass-through entity.
• Provides for a capital gains deduction—as allowed for owners—from net income for capital gains allocated to owners who are subject to income tax.
• Requires the pass-through entity tax credit being claimed by the owner to be included in base income in the same year. This inclusion will reduce the potential benefit of the election for the individuals.
• Clarifies that the credit for taxes paid to other states is calculated prior to reducing tax by the pass-through entity tax credit.

We’re Here to Help

For guidance on pass-through entity tax in New Mexico, contact your Moss Adams professional.

You can also check out our Tax Planning Resources or our State & Local Tax Services to learn more.