What is the Pass-Through Entity Level Tax and How It Can Help the Construction Industry
By Warren Hennagin, California Construction Leader
What is the Pass-Through Entity Level Tax, and how can it help the construction industry? Since individuals own the vast majority of construction companies through S corporations or Partnerships, the PTET (Pass-Through Entity Level Tax) can save your individual tax clients substantial amounts of money. Let’s take a deeper dive into this tax and its benefits.
Since the Tax Cuts and Jobs Act (TCJA), P.L. 115-57 limited the State and Local tax deduction to $10,000 on an individual’s tax return; many professionals have been trying to get around this issue. Individuals in states like California and New York spend more than $10,000 on their residential property tax each year. This leaves no deduction at the federal level for any state income taxes. The IRS issued Notice 2020-75 in November 2020, saying that it intended to issue proposed regulation to clarify that “specified income tax payments” imposed on and paid by PTET are included in the taxable year of payment. The IRS wanted to make sure that only those tax payments paid in the tax year would be deductible. State tax payments by a taxpayer for federal tax purposes are generally only deductible if the payment is paid in the year on a cash basis, irrespective of the taxpayer’s accounting method. Even if the tax is not due until possibly March of the following year, for the individual to deduct at the personal tax level, the tax must be paid in the year the income flows. Any taxes paid at the due date will only be deductible the following year.
In 2021, 16 states enacted legislation allowing S corporations and Partnerships to pay tax, which an individual would otherwise pay, on income passed from a company to an individual, to get around the SALT (State and Local Tax) deduction. This state tax payment would reduce the company profits for federal tax purposes, thus allowing for the SALT deduction at the company level. Each state has its method for electing and paying the tax, and determining whether an annual election must be made. This article will not go into the specific requirements for each state but will provide information that should help you reduce your tax burden. One state, Nebraska, has enacted legislation that will allow retroactive PTET to 2018.
As of June 2023, 36 states and New York City have enacted PTET tax law changes. Three states have proposed PTET tax bills. Nine states have no owner-level personal income tax on pass-through income. Three more states have not yet proposed or enacted PTET taxes. This accounts for all 50 states and the District of Columbia.
PTET is a state or other jurisdiction’s mandatory or elective entity-level income tax on S corporations and partnerships income. Each state prescribes its formula for calculating the tax. Still, in basic terms, it is the amount of tax an individual would eventually pay on the income when it passes down to the individual tax return. Professional organizations, such as the AICPA, have asked the IRS to clarify such issues as passive vs. nonpassive income, accrual basis taxpayers, and certain other issues specific to S corporations. One example of an issue affecting S corporations is that the deduction of the PTET is based on ownership percentage, but not all S corporation shareholders are eligible to have PTET paid on their behalf.
In an early attempt to declare the SALT limitation unconstitutional, four states sued the federal government, the Treasury, and the IRS. However, district courts and the Second Circuit held that the limitation did not violate the Tenth Amendment. The Supreme Court declined to review the lower court’s decision. The SALT limit is here to stay. States then proposed their own method to tax partnerships and S corporations, in which the tax paid at the corporate level will flow as a credit to the individual business owner towards their personal state income taxes. Again, each state has determined when and how the tax is calculated and paid. Certain states, such as Connecticut, have made PTET mandatory.
The mechanics of the tax appear simple, a state imposes a rate of tax on the income derived from that state. The tax is paid to the state on the company’s tax return, which allows a credit to be listed on the K-1 provided to partners or S corporation shareholders. The credit offsets any tax at the individual level, and any balance must be paid by the taxpayer. Any overpayments might be credited for the following year or possibly refunded.
The savings to the individual taxpayer is the amount of the credit times their respective federal tax rate. In most cases, the state tax paid does not benefit an individual taxpayer’s federal return. If you received a PTET credit of $100,000 and are in the 37% federal tax bracket, your savings is $37,000. Additional benefits we see with PTET are prior to TCJA. Individuals also may have had to pay an Alternative Minimum Tax (AMT) because state taxes were not a deduction for the calculation of AMT. That is another large benefit of the deduction of PTET at the company level.
The following states have enacted a PTET tax:
|Missouri||Mississippi||Montana||North Carolina||Nebraska||New Jersey|
|New Mexico||New York||Ohio||Oklahoma||Oregon||Rhode Island|
|South Carolina||Utah||Virginia||Wisconsin||West Virginia|
The following states have proposed PTET tax bills:
These states do not have an owner-level personal income tax:
|Alaska||Florida||New Hampshire||Nevada||South Dakota|
These states have not proposed or enacted a PTET tax:
|District of Columbia||Delaware||North Dakota|
How does this affect the construction industry? Cash has always been king in the construction industry. The more you have, the better you operate. For construction companies, saving cash is paramount. Generally, any taxes paid at the individual level on the profits of the construction company must come from some source. Since the tax is from the profits, generally, the partners and S corporation shareholders must make some type of distribution to pay the tax. These distributions are a reduction of equity and sometimes get lost in following the true operating profits of a construction company. The PTET tax is generally still considered a distribution even when paid by the company.
For a construction company that pays lower taxes due to the PTET tax, taking advantage of paying at the company-level is a way to bid smarter and possibly win a few more jobs. The banks and sureties are always looking closely to ensure that a construction company pays its fair share of taxes, but there is a way to be smarter about corporate taxes. Tax savings generate more working capital at a time when interest rates have increased, and the use of a company line of credit is under greater scrutiny. Saving from PTET goes hand in hand with other tax savings, such as the Qualified Business Income Deduction and Net Investment Income Tax, all of which a construction company should utilize. To maximize tax opportunities, seek out a CPA with a solid understanding of how little mistakes can cost a construction company, or individual owners, tax dollars unnecessarily.
Did your CPA recommend PTET?
If your company is a partnership or S corporation and you have not heard or been told about the Pass-Through Entity Level Tax, it is time you discuss this option with your tax professional or CPA. The savings can be significant and can’t be recovered with amended tax returns. The main issue with the tax is that it must be elected proactively. This means that it must be elected before or during the entity’s tax year. This election can’t be made or altered after the year is over. If you miss the timeframe, you will have to wait until the next year.
For example, in California, if we win a new client in July and they have not made the election/partial payment of the PTET by June 15th, they are out of luck for that year. The only way around the rules is if the company did not exist on June 15th. This election is only available if made by June 15th. Paying the tax late is not allowed and will most likely be rejected by the Franchise Tax Board. Like other taxes that carry a penalty and interest when paid late, this is not permitted for PTET because it is an annual election. In the tax code, elections can’t be correct or elected after the fact, even by filing an amended tax return.
Another benefit we have experienced with our clients is the ability for California taxpayers to pay PTET on the Net Income after state adjustments, not just the net income apportioned to California. This is because California taxes individuals on total income, with a credit for income taxes paid to another state. This allows for the PTET to be calculated on a higher income value, thus producing a large PTET tax credit to offset the personal income taxes of the individual taxpayers of the construction company. This benefit is only for contractors who work in multiple states and reside in California.
Effect on financial statements
How is PTET reported on your financial statements? According to the AICPA, PTET must be recorded as a distribution from equity for partnerships and S corporations. The PTET does not get recorded as part of your provision for income taxes on the income statement of the company. The reasoning is that this is an elective tax that benefits the individual and is not a required tax for a business. In a state such as Connecticut, however, PTET is mandatory, so in this case, PTET is an income tax expense for companies doing business in that state. Footnote disclosures regarding the payment of PTET taxes at the business level are essential because the company will want the reader of the financial statement to know that the partners or shareholders have taken additional distributions that reduce equity but are payments for income taxes on profits that would normally be taken from the business. Banks and bonding companies track the income taxes on the profits of partnerships and S corporations. Because there is no provision for income tax in the financial statement, they will estimate the amount of money that must be taken out of the business for income taxes. It is imperative that your CPA provide detailed footnotes that show the amount of income taxes on profits and if the ownership will need to take any additional distributions to fund their tax liability. The working capital of a construction company has become more important than equity. Banks and Bonding companies are analyzing whether construction companies can meet their weekly and monthly cash requirements. The industry must finance the cost of labor, generally on a weekly basis, when the billings from customers and property owners are not received for 45 to 60 days on average. We have certain contractors that perform emergency road repairs for DOT’s that might not be paid for six months due to the nature of time and material invoicing and the need to provide more documentation than normal.
The PTET is a valuable deduction that most contractors should take in advance. Marcum is an industry leader in the taxation of Construction Contractors. If you would like a second opinion, please contact any of our offices nationwide.