How does a state pass-through entity tax deduction affect owners’ tax returns?

Ever since the Tax Cuts and Jobs Act of 2017 (TCJA) capped the individual state and local tax (SALT) deduction at $10,000 annually, taxpayers and states have searched for legitimate ways to work around the limitation. The first of these efforts to gain approval from the IRS is a state-imposed entity-level tax on pass-through entities (PTEs), such as partnerships or S corporations. Many states passed legislation that allows PTE owners to elect to pay tax at the entity level as opposed to the owner level. PTEs that pay state income taxes at the entity level can then deduct the amounts paid when determining federal ordinary income, in effect creating a deduction for state income taxes that’s not subject to the $10,000 limitation.

Almost all states that impose an owner-level personal tax on PTE income have enacted or are considering creating a pass-through entity tax (PTET). The rules that govern these entity-level tax elections and the effects on the personal income taxes of owners vary significantly from state to state. When states began enacting PTET regimes, it was possible the election would favor one owner by reducing overall federal and state tax paid while increasing the overall federal and state tax paid by another owner. Although the issue of increasing the tax burden of certain individual owners has largely been resolved by the states, there are still areas causing significant owner-level differences. Therefore, it’s critical to consider the tax impacts of all owners — individuals and entity owners alike — when determining whether to make PTE elections.

How does a PTET election affect an individual owner’s tax computation?

The eligibility requirements as well as the tax computations can be quite burdensome depending on the facts and circumstances of the PTE and the state’s PTET laws. Some calculations may be simple if you only have a PTE whose owners and entity activity are limited to one state. Unique challenges exist if the entity is a multistate business and its owners are residents of multiple states.

When it comes to computing income subject to tax at the state level, states generally use federal taxable income as the starting point and further adjust it based on individual state tax rules. Some states exclude income from the state tax base that was subject to a PTET. Other states require taxpayers to include the income that was subject to a PTET and allow a credit for taxes paid to other states. Some states require this credit to be taken at the entity level and some require the credit to be taken at the individual level. The complexities can seem endless when considering all the differences among the various state-enacted PTETs.

Another aspect to consider when making the election is whether the PTET paid to a state is refundable at the owner or pass-through level. Some states, such as New York, allow for the credits to be refunded while other states, such as California, only allow for credits to be carried forward. Since California has a graduated rate for individuals, it’s possible that some PTE owners may not be able to fully claim a credit for taxes paid to California if the PTE tax rate is higher than the rate imposed at the individual level.

In addition to different calculations based on residency, the type of PTE could impact how income is to be apportioned. Therefore, further consideration needs to be made based on whether the PTE is a partnership or an S corporation. The rules in place for S corporations aren’t always the same when computing the apportionment factor for partnerships. Because income might be apportioned differently for an S corporation owner as opposed to a partnership owner, the election can significantly impact various owners’ tax liabilities, the state in which returns are filed, and the state where the PTE owners reside.

A very fluid situation with PTET deductions

Although most states have passed legislation allowing for PTE elections, many questions remain on specifics to the mechanics of each PTET. The result is that taxpayers are attempting to comply with rules while at times only having access to limited guidance outside of statutory language and ever-changing state guidance. Taxpayers should continue to monitor each state for further guidance, as changes to existing elections are continually being refined and updated.

If you have questions about the impact of a PTET election, either in your role as an executive at a PTE or as an owner of one, please contact your Plante Moran advisor or one of the authors to discuss the specific facts and circumstances of your situation.