Close-Up on Pass-Through Entity Tax Laws

At the start of 2024, three dozen states and New York City already had pass-through entity taxes (PTETs) on their books, with legislation pending in three other states. These types of workarounds for the current $10,000 cap on the federal deduction for state and local taxes (SALT) have become more prevalent. But they aren't necessarily the right option for every pass-through entity, partner or shareholder. Businesses and their individual owners must consider the pros and cons before electing this tax treatment.

The Basics

PTETs developed as a response to the SALT limit imposed by the Tax Cuts and Jobs Act of 2017 that applies to tax years 2018 to 2025. The limit was particularly harmful to the owners of pass-through entities, which aren't taxed at the entity level. Instead, the income, gains, losses and deductions "pass through" to the partners or shareholders to report on their individual tax returns. With the limit in place, many of these taxpayers lost out on what had previously been more substantial deductions, especially if their businesses paid SALT in multiple states.

The precise mechanics of a PTET vary by jurisdiction. But the general goal is to shift the state tax burden for pass-through entity income from the individual partners or shareholders to the entity. Typically, they allow eligible pass-through entities to pay a mandatory or elective entity-level state tax on business income with an offsetting tax benefit at the owner level. The benefit usually is a full or partial tax credit, deduction or exclusion. The business itself can deduct the full amount of the state tax paid as a business expense.

Although early attempts to craft a SALT deduction limit workaround were rejected by the IRS, it explicitly approved PTETs in 2020. The IRS stated that SALT imposed on and paid by a partnership or an S corporation on its income can be deducted by the entity when computing its taxable income or loss for the tax year of the payment. The IRS further clarified that such payments aren't taken into account when applying the SALT deduction limit to individual partners or shareholders who itemize their deductions.

Differences from State to State

The different PTET laws currently in effect all take the IRS stance into account, but the differences among the laws often are significant. For example, South Carolina makes its PTET available only for "active trade or business income," and Louisiana doesn't allow entities that file composite partnership returns to elect the PTET.

Other differences relate to:

• The timing and other election requirements,
• The revocability of an election once made,
• The calculation of the entity-level tax base,
• The application to tiered partnerships, and
• The refundability of excess PTET credits.

Owners must closely scrutinize the provisions of each PTET that might apply to their business.

Some Pros and Cons

Avoiding the $10,000 cap on SALT deductions is an obvious benefit of a PTET. But that's not the only possible upside. For example, a PTET could reduce a pass-through owner's adjusted gross income (AGI). A smaller AGI can lead to other tax benefits, such as the ability to deduct rental losses. It also could cut an owner's liability for the net investment income tax and increase the amount he or she can contribute to a Roth retirement account.

But it's not all upside, particularly if a business has nonresident owners. A PTET election won't pay off for nonresident owners, unless their state of residency allows a credit for taxes paid to another state where the income is earned at the entity level. If the credit isn't permitted, such owners may face double taxation. Nonresident owners also might be subject to nonresident individual filing requirements in some states.

Even if all a business's owners are residents, a PTET election could have unwanted consequences. For example, some states require estimated payments throughout the year for PTET, which could affect a business's cash flow. Further, businesses that are subject to taxes in multiple states with different PTET approaches will shoulder a hefty compliance burden to satisfy the varying requirements, many of which have gone through post-enactment modification.

Additionally, owners should weigh the effect of a PTET election on their overall tax liability, both federal and state. For example, electing the PTET could reduce an owner's federal qualified business income (QBI) deduction. Moreover, it could result in higher state taxes, depending in part on how the PTET rate compares with an owner's applicable individual state income tax rate.

Proceed with Caution

The initial allure of a PTET election could be offset by some of the adverse side effects. In addition, Congress continues to discuss various avenues of SALT relief, and the SALT deduction limit is scheduled to expire after 2025, unless Congress passes legislation to extend it.

With so many relevant factors—as well as the lack of formal guidance from the IRS—a PTET election requires comprehensive analysis. Contact your SSB tax advisor to determine what's right for your situation.

©  2024