Many high-income taxpayers were negatively impacted when the Tax Cuts and Jobs Act of 2017 (TCJA) imposed a $10,000 limit on the individual federal income tax deduction for state and local taxes (SALT). This $10,000 limit is often referred to as the “SALT cap.” In response, over two dozen states and one locality, New York City, have since implemented pass-through entity taxes (PTETs) that provide a workaround for those eligible.
The SALT cap has proven especially painful for owners, members and shareholders in pass-through entities (S corporations and partnerships). These taxpayers historically have seen their entities’ state-level tax expenses “flow through” to them individually and took advantage of deducting the state tax owed as an itemized deduction on their individual returns without a cap. With TCJA’s enactment of the $10,000 SALT cap, many high-income taxpayers lost the benefit of deducting the full amount of individual state taxes paid on their flow-through income.
PTETs take advantage of the fact that the SALT cap applies only to individuals, not businesses. The particulars of the various PTETs vary by jurisdiction (see Sidebar, “California, New York Laws Illustrate the Differences,” below), but they generally allow covered pass-through entities to pay a mandatory or elective entity-level state tax on business income. The entity is then permitted to deduct the full amount of the PTET as a business expense, thereby circumventing the SALT cap in effect at the individual level. The benefit is passed on to the individual owner(s) in the form of a full or partial state tax credit, deduction or income exclusion.
Related Read: Making the Most of the New Pass-Through Deduction
PTETs are not the first workaround to surface at the state level to circumvent the SALT cap. Earlier strategies quickly failed, though, as they were shot down by the IRS. For example, the agency explicitly rejected initiatives in states like New York and New Jersey to allow taxpayers to donate to state-sponsored charitable funds in exchange for credits against their state taxes.
To the surprise of some, the IRS gave its approval for state PTET elections in 2020 in IRS Notice 2020-75. It clarified that SALTs imposed on the income of partnerships or S corporations are deductible by the entity and not subject to the SALT limit for partners and shareholders who itemize their deductions. The IRS has indicated it intends to issue proposed regulations with further guidance, but such regulations had not been published at the time this article was drafted.
Many law firms are well positioned to take advantage of the PTET approach but will need to do some planning. States, for example, have deadlines for when an entity must make its annual election and in some states the election is irrevocable. In addition, consent forms must be obtained from owners, members and shareholders (or at least notice must be given to them) to make the election.
It is also worth considering that the election will not necessarily help every owner; in fact, it could be detrimental to some. An attorney might, for instance, live in a state that does not allow credits for PTET paid in another state, which would reduce the election’s benefit — and create a double-taxation situation for the attorney.
Law firms considering this option should consider where the owners, members or shareholders live and their other income sources, as both of these factors could affect how an election plays out. Evading the SALT limit may not prove worth it in light of other effects on federal and state tax liabilities.
Promising but complex
Variations among the state PTETs abound, with differences in everything from eligible entities and how individual taxpayers are credited to election requirements and deadlines. Contact your ORBA advisor to be certain you both minimize your tax liability and comply with all of the applicable requirements.
Related Read: Illinois 2022 Budget to Raise New Tax Revenue
Sidebar: California, New York laws illustrate the differences
The PTET laws in California and New York provide examples of the potential variations in various states’ PTET laws. While both generally allow a pass-through entity to pay tax at the entity level with a corresponding credit at the individual tax level, significant differences exist.
For example, California’s PTET is applied to income which includes only the distributive shares of those partners, members or shareholders who consent to the election. In New York, however, the PTET income includes the income of all partners, members, or shareholders, regardless of whether they consent. The pass-through entity income calculation also differs between partnerships and S corporations in New York.
The California credit is nonrefundable, but can be carried over up to five years. Therefore, if a taxpayer overpays California tax in one year and does not have enough California tax liability in subsequent years, the overpayment/credit will be lost forever. In New York, the excess credit over tax due is treated as an overpayment and credited or refunded.
These are just a few of the differences between the two states’ approaches to PTETs. Other states will have even more variations. Therefore, it is imperative to perform a comprehensive analysis of the effects of a PTET election at all levels of taxation before taking the leap.
For more information, contact Manal Shalabi at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Law Firm Group.