In response to the $10,000 federalcapplaced on deducting state and local taxes(SALT),somestatesare enactingoptional pass-through entity taxesas a workaroundto the cap.Theelectivetaxesallow eligible pass-through entities to deduct state taxes at the entity level for federal tax purposes, while providing a credit or income exclusion to the entity owners for state income tax purposes.
Why Enact Pass-Through Entity Taxes?
Most states did not impose a pass-through entity (PTE) level income taxprior to the enactment of the Tax Cuts and Jobs Actof 2017 (TCJA).Then the TCJAcapped the deductionavailable to individual taxpayers underIRC Section 164for tax years beginning after 2017 and before 2026. The deduction is limited to $10,000 ($5,000 in the case of a married individual filing a separate return) of the following state and local taxes:
Income taxes, or general sales taxes if elected instead of income taxes
Real property taxes
Personal property taxes
Statesattemptedseveral workaroundsto the SALT capwithvaried results.A growingnumber of states are enacting anoptionalpass-through entity taxthathas met with some success.
WhatIs anElectivePass-Through Entity Tax?
Theowners ofaPTEaretypicallyresponsible forpayingthetaxeson theentity’staxable income.The optional tax allows eligible PTEs toshift thepayment ofstate income taxestothe entity. Those income taxes can then be fully deducted for federal tax purposesby the entity. The deduction is passed through in the distributive share of the PTE owners’ income.At the state level,the laws enacting theseelectivetaxesusually allow the owner to:
Claim a credit for the amount of the owner’s distributive share of the taxes paid by the PTE; or
Allow the owner to exclude their distributive share of the PTE’s income.
WhatIs the Impact of Notice 2020-75?
The issuance ofNotice 2020-75in late 2020may have prompted even more states to enact elective PTE tax laws.
The Notice clarifies that partnershipsandS corporationsmaydeductstateincome tax paymentsat the entity level.Thesepayments are not taken into account:
Separatelyunder IRCSections702 or 1366 indetermining the partner’s or shareholder’s ownfederal income taxliability;or
in applyingthe $10,000 limit ($5,000 for married taxpayers filing separate returns)toan individual’s SALT deduction.
The IRS and Treasury Departmentintendto issue regulations on the treatment of state and local income taxes imposed on and paid by partnershipsor S corporations. In the meantime, taxpayerscanrely on theNotice provisions prior to the issuance of the proposed regulations.
Which States Enacted anElectivePTE Tax?
Nearly half of the states with a state income taxhave enacted an electivePTEtaxthat allows owners to circumvent the SALT cap.Connecticut has a mandatoryPTEtax.See the map below for a list of statesthathave enacted anoptional pass-through entity tax.
Additionally,Iowa, Ohio, and Pennsylvaniahave proposedPTE taxlegislation.
Whatto Consider Before Makingan Election
Severalissues should beaddressedin deciding whether to make the election to be taxed at the entity level, such as:
Determining ifsomeownerswould benefitdisproportionatelychanging thepreexistingagreementamong theowners.
Thetax consequences toPTE ownersin their resident statewhere thatstatedoes notallow a resident taxpayer to claim acredit for their share of taxes paidto another statebytheentity.
Anyadditional administrative, legal, oraccounting costs.
Ifthe election would be beneficial for mostowners, but the PTEis ineligibledue to non-qualifying owners,theymay want to look at restructuring the entity.The PTE could bereorganized to only include eligible ownersandsoqualifyfor the election.
Many statesthat enacted elective PTE taxesinclude provisions allowing the tax toexpire after tax year 2025to align with the end of theSALT cap.Also,many of the stateelective lawswill be repealed sooner if the $10,000 state and local tax deduction limitation in IRC Sec. 164 is repealed.
