Since the 2017 Tax Cuts and Jobs Act (TCJA) put a limit on itemized deductions for state and local taxes (SALT), states with relatively high tax rates have been looking for ways to work around the limit. One widely used approach can lessen the impact of the SALT deduction cap for some taxpayers, but it also creates complications for businesses.
Residents in high-tax states are not the only taxpayers affected by this issue. Businesses that generate revenue or have other interests in those states are also subject to their tax laws, even if they and their owners are based elsewhere. Complying with multiple jurisdictions’ tax regulations is inherently complicated. Determining whether to make the necessary elections to work around the SALT deduction cap only adds to the complexity.
How We Got Here
Traditionally, individual taxpayers could deduct state and local taxes from their taxable income on federal returns with few limitations. But the TCJA capped those deductions at $10,000 per taxpayer, and the IRS subsequently disallowed most of the ideas proposed by state legislatures to ease the limitation.
One approach that passed IRS scrutiny was a workaround known as an elective pass-through entity (PTE) tax. In most states, pass-through entities—such as partnerships, limited partnerships, S corporations, and most LLCs—do not pay income taxes directly. Instead, they pass their income through to partners or shareholders, who pay the taxes on their personal returns. A PTE tax changes that.
With an elective PTE tax, an entity may choose to pay state income taxes directly and then deduct that payment on its federal return as an “ordinary and necessary” business expense—without regard to the $10,000 limit—thus lowering the taxable income that is passed through to the owners. That’s because IRS Notice 2020-75 specifically exempted elective PTE taxes from the SALT deduction cap.
Note, however, that this exemption applies only to state or local taxes on individuals’ pass-through income. Their property taxes, motor vehicle taxes, and taxes withheld on W-2 wages are still subject to the $10,000 itemized deduction limit. In addition, the PTE election is available only to multiowner entities taxed as partnerships or S corporations. Sole proprietors and single-member LLCs don’t qualify.
So far, 30 states have enacted some form of elective PTE tax, and several more are considering it. Unfortunately, every one of those states has its own version, resulting in a bewildering array of provisions that greatly complicate business owners’ decisions about how and when—or even whether—to make the election.
Variations, Variables, and Details
Here are some—but by no means all—of the variables that businesses must consider when deliberating a PTE tax election:
- Who decides? In some states, the decision to opt for an elective PTE tax is made at the entity level and all partners or shareholders are bound by the decision. In others, the individual owners choose for themselves. And in Connecticut, the PTE tax is not elective at all but is mandatory for all eligible entities.
- Credit or exclusion? Most states that allow a PTE tax election give owners a credit on their state income tax returns to reflect the tax already paid by the entity. But in some states, taxpayers exclude their share of the PTE’s income from their personal state returns, so no credit is needed.
- Allocating taxes among entity owners. In states where individual owners get to make the election, the entity must find a way to allocate the PTE tax and its offsetting credit among various owners—without creating separate shareholder classes or violating partnership agreements.
- Tax rate. In some states, the income tax rate for elective PTEs is equivalent to the highest individual tax rate. Other states set lower rates for PTEs, while still others use graduated rates.
- Payments and deadlines. In some states, an entity simply elects to pay the PTE tax on its annual tax return. In others, it must file an election earlier and make estimated payments during the year.
- Revocability and expiration. In some states, the PTE tax election is permanent and irrevocable. In others, the election is made annually. In many states—but not all—the election will expire if the SALT cap sunsets as scheduled after 2025.
- Resident and nonresident owners. PTEs with multiple owners residing in several states face numerous complications including variations in filing, reporting, and withholding requirements. The pros and cons of the election also vary, depending on the taxpayers’ residencies.
- Impact on other taxes. Because the PTE tax changes taxable income, electing to participate can affect other federal income tax provisions such as the Section 199A qualified business income deduction.
For businesses with activities or owners in several states, the complexities involved in assessing the various jurisdictions’ PTE tax alternatives can be significant —and some questions remain unanswered. The IRS promised in November 2020 that additional guidance would be forthcoming, but none has been issued since then.
Moreover, the picture is still changing. The SALT deduction cap is scheduled to expire at the end of 2025, and there are competing proposals in Congress to extend it, modify it, or end it altogether. The uncertainty makes long-term planning difficult and presents many PTE owners with decisions that require extensive analysis.
Please contact us for more information on this and other tax-related topics.