Many states have introduced pass-through entity (PTE) taxes as a workaround to the $10,000 cap on deducting state and local tax (SALT) expenses enacted by the Tax Cuts and Jobs Act of 2017. These mostly elective taxes allow eligible PTEs to deduct state taxes at the entity level for federal tax purposes, while providing a credit or income exclusion to the PTE owners in those states.
Overview of Pass-Through Entity Taxes
Typically, PTEs are not subject to an income tax at the entity level. Rather, PTE owners are responsible for paying the state income taxes on their distributive share of the entity’s taxable income. With this $10,000 cap, taxpayers in states (or with activity in states) with higher personal income tax rates were adversely affected by this legislation. As such, those states had incentive to find a workaround.
IRS Notice 2020-75 essentially approved PTE taxes as a workaround to avoid the $10,000 cap, allowing the PTE to deduct these state taxes at the entity level. Prior to the enactment of the TCJA, few states had a PTE-level income tax; today, more than half do. However, the election process and computation of the PTE taxes are unique to each state.
Below is a map that shows all states that have a PTE tax election enabled for tax years 2022 and earlier. Missouri and New York City have a PTE tax election beginning January 1, 2023. Four states (Iowa, New Mexico, Pennsylvania, Utah) have pending legislation to enact a PTE tax.
What Effect Does Pass-Through Entity Election Have?
The key benefit to a PTE election is the full federal deductibility of the entity’s state income taxes paid with a PTE tax. While the income and tax reported is dependent on each state’s rules, there is no federal limit to the amount of PTE tax that is deductible. Thus, there is no limit to the amount of federal tax reduced.
Assuming a 35% marginal tax rate, a PTE tax of $100,000 could result in a $35,000 federal tax savings. The exact amount of tax saved depends on tax brackets and other federal tax rules, but this can be a sizeable deduction. This is in addition to the maximum $10,000 deduction still allowed for other state and local taxes.
How Does Pass-Through Entity Eligibility Differ Between States?
For residents of states with no personal income tax, the decision on whether to elect into PTE taxes may be easier. All states allow the PTE tax to be used on the owner’s personal income tax returns, either via credit or income reduction. However, not all states give credit to resident owners for PTE taxes paid to other states. For those states that do give credit, they generally require the other state’s PTE tax be “substantially similar,” though not all define the term. As such, there is a risk of double state taxation, which may negate the federal tax benefit altogether.
Some states may evaluate resident PTE owners differently from nonresidents. For example, New York requires resident partnership owners to include all their income in the New York PTE tax calculation, while nonresidents are only taxed on their New York-sourced income (S-Corporations are only taxed on New York-sourced income). PTEs must consider their partnership or corporate agreements when considering PTE taxes; depending on how the ownership agreements require income and expenses to be allocated, owners may get a disproportionate share of the PTE deduction.
States may also treat various owner entity types differently. All state PTE taxes permit individuals to be included in the filing. However, other owner entity types (trusts, estates, corporations, other partnerships) may vary in eligibility by state. This requires PTEs to carefully consider those ownership agreements with PTE taxes, as there may be additional concerns regarding the allocation of the PTE deduction.
Timing of the Election:
As each state enacts PTE taxes, they have different rules for that enactment, including timing. For example, New York requires a 2023 election be made by March 15, 2023, while other states require the election be made with a timely filed return in the 2024 filing season.
Timing of the Deductibility of PTE Tax Payments:
PTEs may deduct state and local tax payments at the federal entity level in computing taxable income or loss. Even though such payments are generally deductible in the year the taxes are “paid or accrued,” Notice 2020-75 specifically indicates that the deduction is allowed “in computing its taxable income for the taxable year in which the payment is made.” So, even if the state permits registering for a PTE tax with a timely filed return, payment may need to be made during the taxable year for a deduction that year.
PTE tax elections may be a way to substantially save federal income taxes for PTE owners, while still fulfilling all state tax filing and payment requirements. The variation in different state PTE taxes and the PTE’s structure and ownership itself must be taken into consideration when deciding whether to elect into any state’s PTE tax. A PTE must consider the combined federal and state tax consequences of each individual PTE tax before electing.
If you have questions regarding PTE tax elections, please reach out to Clark Nuber’s SALT team.
Josh Stein is a senior manager in Clark Nuber’s SALT Services Group.
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