Optional Pass-Through Entity Tax
Optional Pass-Through Entity Tax
In response to the $10,000 federal cap placed on deducting state and local taxes (SALT), some states are enacting optional pass-through entity taxes as a workaround to the cap. The elective taxes allow eligible pass-through entities to deduct state taxes at the entity level for federal tax purposes, while providing a credit or income exclusion to the entity owners for state income tax purposes.
Why Enact Pass-Through Entity Taxes?
Pass-through entity (PTE) level income taxes had not been imposed by most states. Then the Tax Cuts and Jobs Act capped the deduction available to individual taxpayers under IRC Section 164 for tax years beginning after 2017 and before 2026. The deduction is limited to $10,000 ($5,000 in the case of a married individual filing a separate return) of the following state and local taxes:
- income taxes, or general sales taxes if elected instead of income taxes;
- real property taxes; and
- personal property taxes.
As a workaround to the SALT cap, a number of states are enacting an optional pass-through entity tax.
What is an Optional Pass-Through Entity Tax?
The optional tax allows eligible PTEs to pay state income taxes at the entity level. Those income taxes can then be fully deducted for federal tax purposes. The deduction is then passed through in the distributive share of the PTE owners’ income. The laws enacting these optional taxes usually allow the owner to:
- claim a credit for the amount of the owner’s distributive share of the taxes paid by the PTE; or
- allow the owner to exclude their distributive share of the PTE’s income.
What is the Impact of Notice 2020-75?
The issuance of Notice 2020-75 may have prompted even more states to enact elective PTE tax laws.
The Notice clarifies that the partnership or S corporation is allowed a deduction for the income tax payment. The payments are not taken into account by a partner or shareholder in determining federal income tax liability or the $10,000 limit ($5,000 for married taxpayers filing separate returns) on an individual’s SALT deduction.
The IRS and Treasury Department intend to issue regulations on the treatment of state and local income taxes imposed on and paid by partnerships or S corporations. In the meantime, taxpayers can rely on the Notice provisions prior to the issuance of the proposed regulations.
Which States Most Recently Enacted an Optional PTE Tax?
A number of states have enacted an elective pass-through entity tax, and Connecticut has a mandatory pass-through entity tax, that allows owners to circumvent the SALT cap. Other states, including Illinois where the legislature passed an elective pass-through entity tax, may still be considering it.
States that most recently enacted an optional PTE tax include:
- Arizona allows partnerships and S corporations to elect to pay Arizona income tax at the entity level beginning with tax year 2022. Owners may claim a credit against the state income tax for their share of the tax paid by the entity.
- California allows certain qualified PTEs to elect to pay an entity-level tax on behalf of their consenting owners for tax years 2021 through 2025, unless there is a change in the federal SALT limitation. Owners may claim a personal income tax credit for their share of the tax paid by the entity.
- Colorado pass-through entities may elect to pay their state income tax at the entity level beginning in tax year 2022 and only for tax years when the federal SALT limitation remains in effect. Owners do not take into account the entity’s income attributable to the state and not attributable to the state.
- The Massachusetts legislature voted to override the Governor’s veto and allow an elective pass-through entity tax beginning with tax year 2021 and in effect until the federal limitation on the SALT deduction is repealed or the limitation expires. A credit for the PTE tax paid is allowed equal to the owner’s proportional share of the tax paid multiplied by 90%.
- Minnesota allows qualifying PTEs with only individual, trust, and estate owners to elect to pay a PTE tax beginning with tax year 2021 and applicable as long as the SALT cap remains in effect. Owners may claim a credit against the state income tax for their share of the tax paid by the entity.
- Oregon allows an elective entity-level income tax on qualified PTEs for tax years 2022 and 2023. The optional tax is repealed if the federal limitation is repealed. Owners may claim a credit equal to the member’s pro rata share of the tax paid for the tax year.