Pass-Through Entity Tax Workarounds by States
Pass-through entity owners will be the beneficiaries of the first IRS-approved workaround to the controversial limit on state and local tax (SALT) deductions enacted by the Tax Cuts & Jobs Act of 2017. The Act limited taxpayers’ personal income tax deductions to no more than $10,000 of total state and local taxes, starting in tax year 2018. In late 2020, the IRS formally approved a workaround allowing entity-level taxes of pass-through entities (PTE) at the state level, as opposed to a withholding or related tax that would be subject to that SALT deduction limit.
Connecticut was the first state to enact such a workaround. Connecticut’s PTE tax is mandatory for all PTEs that conduct business in the state (provided they have taxable income in Connecticut) and replaces its PTE withholding tax. The tax is a business expense that lowers taxable income.
As of September 29, 2021, 20 states had enacted new PTE taxes (AL, AZ, AR, CA, CO, CT, GA, ID, IL, LA, MD, MA, MN, NJ, NY, OK, OR, RI, SC, WI). While the ultimate goal is the same (to help business owners avoid the $10,000 SALT deduction limit), each state has specific rules and procedures on how to elect its PTE program, ranging from a separate online election to a special election form to a checkbox on the annual tax return.
The most significant potential advantage to these state PTE taxes is the effective elimination, or workaround, of the $10,000 SALT deduction limit on state taxes paid. These state PTE taxes are treated as business expenses, which will lower taxable business income for the business owners.
There are two potential disadvantages to electing into these state PTE taxes. First, not every state provides resident owners a deduction for PTE taxes paid to other states. This could result in two states fully taxing the same income, which would negate any advantage of avoiding the SALT deduction limit. Second, depending on the state and the PTE tax rate, business owners could end up paying more to a state by electing into a PTE tax than they would have under prior methods. As these taxes are generally paid at a state’s top marginal tax rate (or in a couple of cases, potentially above the top marginal tax rate), the outcome could be significant and could be near or in excess of the tax savings generated federally.
Taxpayers should perform an analysis to determine if electing PTE treatment is favorable to their individual facts and circumstances. Due to the many moving parts in such an analysis, one size does not fit all taxpayers.