In response to the Federal Tax Cuts and Jobs Act (TCJA), many states now allow a pass-through entity (PTE) to pay the tax at the entity level as opposed to the individual level to avoid the $10,000 limitation imposed by the TCJA. Most states passed legislation allowing for pass-through entity taxes, and they continue to issue guidance and clarifications. Before making a pass-through entity tax election (PTET) election, it’s important to understand the eligibility requirements and effectively make the election and meet corresponding filing requirements. These rules vary by state, so proceed with caution to make sure all eligibility requirements have been met and are properly documented.
Is every PTE eligible to make a PTET?
Owners of partnerships, LLCs taxed as partnerships, and S corporations are generally able to make a PTE election in the states that allow PTETs. However, solely being a PTE doesn’t automatically qualify the owners to make the election. The statutes vary by state, and a PTE could be ineligible solely if one of its owners isn’t a qualified member (such as a C corporation or another PTE owner). These rules can be overly burdensome when dealing with tiered business structures where the ultimate owners vary from individuals, C corporations, S corporations, LLCs, and trusts. Before making the election, it’s important to understand the entire makeup of the PTEs’ owners to determine if they’re eligible to make the election and what, if any, benefits will be received.
How does a PTE make a PTET election?
Requirements to elect PTET treatment vary by state. If the election isn’t made in a timely manner or is made incorrectly, any benefit the owners may have received may be lost. Taxpayers that want to elect PTET treatment will need to understand and follow state-based procedures. In some states, there may be limited guidance, and the rules continue to evolve.
Here are some examples of the current state requirements to show how varied the election and reporting process can be:
- California’s election is made on an annual basis, and, in order to qualify, the PTE needs to make an estimated payment by June 15. Once the election is made, it’s irrevocable for that year and is binding on all qualified partners, shareholders, and members of the PTE. Additionally, , California has provided taxpayers with an option to pay online or via a state-provided form. Certain members’ income, such as C corporations, are excluded from the tax base when computing the amount of PTET due. Qualified owners include individuals, fiduciaries, estates, or trusts subject to California personal income tax and further includes disregarded single-member LLCs owned by an individual, fiduciary, estate, or trust subject to California personal income tax.
- For tax years that begin on or after Jan. 1, 2024, pass-through entities must file their election to pay the PTE tax before the last day of the ninth month after the end of the tax year (e.g., Sept. 30, 2025, for 2024 calendar taxpayers). A member’s share of the tax imposed for the year is creditable against the corresponding income if paid by the date for filing of the annual return, including any extension. Michigan requires all payments and filings to be done online. The Michigan PTE election for tax years beginning prior to 2024 wasn’t as flexible as current law. For example, taxpayers needed to make a payment by March 15, 2024. Any payments received after this date were allowed as a credit on the owner’s 2024 tax return, even though payments made against income that were recognized and taxed on the 2023 return. Additionally, once an election is made, it’s irrevocable and remains in effect for the current tax year and the following two tax years. Michigan owners that qualify include individuals, other PTEs, estates, or trusts. Since the election is a three-year binding election, taxpayers that elected in for the 2021 tax year will need to reelect into the Michigan PTET for their 2024 tax year.
- The Utah PTET election is due by the PTE’s last day of its taxable year, and it must be made electronically. Like California, the credit allowed to its owners is nonrefundable and can be carried forward for five years.
- Other states simply require the entity to make an election on a timely filed return, while other states have created a separate form that must be completed and filed to qualify for PTET eligibility.
These aren’t a complete summary of the rules in place throughout California, Michigan, and other states. Other requirements exist, and it’s important to make sure all requirements are met.
Who bears liability if a PTE fails to meet filing requirements or pay properly?
So, who bears the liability if the PTE fails to file the proper returns and pay the PTET as required by law? Owners who make PTET elections should be aware that states will often pass the liability for these failures to the individuals who own the delinquent PTE. Any failure to comply with a state’s rules can have a cascading effect on the owner’s personal returns. To the extent tax deductions used to determine taxable income were disallowed, individual owners would likely owe federal and state tax, penalties, and interest opposed to these being a liability of the PTE. If PTET filing requirements aren’t followed properly, PTE owners may incur significant federal and state liabilities.
How do owners consent to a PTET election, and how is it documented?
In addition to the election requirements, the states are also inconsistent when it comes to owners’ consent. Not all states have clearly stated these requirements, and careful considerations should be made when it comes to documenting how the PTE owners consented to the election to be taxed at the entity level. Some states require owners to vote on the issue, and it’s common to require at least 50% of the controlling interests to vote in favor of entity-level taxation for it to be effective. For the states that lack specific guidance, the entity’s governing documents may specify what level of consent is needed. In the absence of relevant provisions in the governing documents, the parties should consider revising existing agreements to create a process that supports PTET elections as well as provisions to address owner disputes related to the benefits received or negative impacts.
PTET guidance still forthcoming in many states
Another important thing to keep in mind when determining whether to make a PTE election is that guidance and laws have changed over time. Further, the $10,000 federal deduction for state taxes is set to expire after 2025, which may impact PTET elections if the cap is extended or increased. For example, unless legislation is enacted to extend the PTET election, the PTET election in some states will expire at the end of the 2025 calendar year. Taxpayers should continue to monitor the states for further guidance or potential legislative changes to law.
If you have questions about the impact of a PTET election, either in your role as an executive at a pass-through entity or as an owner of one, please contact your Plante Moran advisor or any of the authors to discuss the specific facts and circumstances of your situation.
