Pass-Through Entity State Tax Legislation Update
A major component of the Tax Cuts and Jobs Act of 2017 (TCJA) was the $10,000 limit (or $5,000 in the case of a married individual filing separately) for the state tax deduction (or SALT cap) for individual income tax return purposes.
Itemized deductions for state income taxes, general sales taxes (if elected instead of income taxes), real and personal property taxes are included in this limitation.
The cap is not applicable to C-corporations or other business entities, which means that it particularly impacts pass-through business entities such as partnerships and S-corporations (PTEs) and their individual partners/shareholders, especially in high-tax states. Under the SALT cap, owners of pass-through entities may be liable for state and local taxes in every state where their business derives income but may only claim a federal itemized deduction for up to $10,000 of all such state-level taxes paid.
TCJA Triggered State Pass-Through Entity Tax Legislation
In response to the $10,000 SALT cap, many states have enacted pass-through entity taxes (PTET) as a workaround to the cap. If income tax is paid by the business at the entity-level rather than on the owner’s individual state income tax return, the SALT cap doesn’t apply for that income. The PTET allows 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.
What are Pass-Through Entity Taxes?
The owners of a PTE are typically responsible for paying the taxes on the entity’s taxable income. The PTE tax allows those eligible entities to shift the payment of state income taxes to the entity. Those income taxes can then be fully deducted for federal tax purposes by the entity. The deduction is passed through in the distributive share of the PTE owners’ income. At the state level, the laws enacting the PTET usually allow the owner to:
- Claim a credit for 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 thereby avoiding double taxation.
IRS Notice 2020-75
In November 2020, the Internal Revenue Service (IRS) issued Notice 2020-75 clarifying that PTEs may deduct state income tax payments at the entity level and that these payments are not considered in applying the SALT cap. Since this guidance applies only to specified income tax payments, business owners are still subject to the SALT cap for state property taxes, sales taxes, or state income taxes on their wages.
The IRS and Treasury Department intend to issue regulations on the treatment of state and local income taxes imposed on and paid by PTE’s; however, in the meantime, taxpayers can rely on the guidance in the notice for making PTE tax payments.
Pass-Through Entity Tax Legislation Sweeping Across the States
Twenty-eight states have enacted PTE taxes and several more are expected to propose and/or adopt PTE tax legislation soon. It was anticipated that many eligible businesses would opt into these workarounds, but that has not been the case yet.
The fact that state tax authorities have not provided clear and sufficient guidance on this tax likely contributed to the low participation rate thus far. For example, in order to make the New York PTET election, the state requires an authorized person of the PTE business to elect into the program via the New York website annually.
Another concern of electing to pay the tax is the risk of double taxation for nonresident partners. For example, if you are not a resident partner of a partnership in a state that the partnership elected into the PTET, your home state may not allow you to claim a credit for the state PTET paid against your resident state income tax liability.
Pennsylvania has not passed any such legislation yet, but House Bill 1709 which is pending in the House Finance Committee, proposes a PTE tax to aid its residents and PTE owners to receive federal tax deductions as well as keeping pace with other states on this issue.
Under current law, a resident owner of a PTE is allowed a credit against Pennsylvania personal income tax for taxes paid to other jurisdictions on the same income. Since Pennsylvania taxes its residents on all income regardless of where it is earned, the credit is necessary to avoid double taxation by other states (under their PTE taxes) and Pennsylvania on the personal income tax return.
However, Pennsylvania has indicated that a resident partner in a PTE is not entitled to a credit against personal income tax, but a Pennsylvania resident S corporation shareholder is eligible for a personal income tax credit. This means that resident partners may face a Pennsylvania tax increase by their inclusion in another state’s PTE tax return. As part of House Bill 1709, the legislation would allow a credit for both resident S corporation shareholders and resident partners in a PTE, thereby correcting the disparate treatment currently penalizing resident partners.
Ohio is the most recent state to enact PTE legislation with Ohio Senate Bill 246 enacted into law on June 14, 2022. Beginning with tax year 2022, a PTE may elect to be taxed by filing a form with the tax commissioner by the deadline to file a return. The election must be made annually and is irrevocable. PTE owners are allowed a refundable credit equal to their proportionate share of the PTE tax which may be used against their personal income tax liability.
Issues to Consider
Before electing into any state PTE program, PTE owners should consider several issues. First, it should be determined if the election for a certain state is made on an annual basis or irrevocable once made. Several states have deadlines for electing into their programs and some elections are required to be made online rather than by simply filing a PTET return. In addition, if the election is irrevocable, a state will generally require that the taxpayer submit a request as to the reason why they would like to elect out and approval to change could be a challenge in certain states.
Next, a taxpayer should determine how the state PTE tax will affect his individual income tax return. Some states allow the individual owners of the PTE to claim an income tax credit for their share of the PTE tax paid by the entity. However, other states have indicated that no credit will be allowed; rather, the state will allow the owner to exclude their distributive share of the PTE’s entity’s income on their individual tax returns. Another consideration is that tax rates for PTEs can be higher than state tax rates assessed at the individual level.
In addition, it is important to realize that these PTE taxes may just be a temporary fix since Congress may consider changes to the SALT cap in coming legislation. The House-passed version of Biden’s economic bill would raise the SALT limitation to $80,000 and extend it through 2030 (reverting to $10,000 in 2031 and then expiring in 2032). The current cap, along with all other individual tax changes in the TCJA, is scheduled to expire at the end of 2025.
While the new PTE taxes can save business owners substantial federal taxes, the states still collect the same amount of income tax on these business earnings since only federal tax liability declines. The pass-through entity-level tax work-around is likely to become increasingly popular among states. While it makes state taxes more complicated, it helps state residents reduce federal taxes at no cost to the states themselves.
At Louis Plung & Company, we will keep you updated on the latest developments. You can also reach out to us at [email protected].