In response to the $10,000 federal cap placed on deducting state and local taxes (SALT) , some states are enacting optional pass-through entity tax es as a workaround to the cap. The elective tax es 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?
Most states did not impose a pass-through entity (PTE) level income tax prior to the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA). Then the TCJA 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:
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Income taxes, or general sales taxes if elected instead of income taxes
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Real property taxes
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Personal property taxes
States attempted several workarounds to the SALT cap with varied results. A growing number of states are enacting an optional pass-through entity tax that has met with some success.
What Is an Elective Pass-Through Entity Tax?
The owners of a PTE are typically responsible for paying the taxes on the entity’s taxable income. The optional tax allows eligible PTEs to shift the payment of state income taxes to the entity. Those income taxes can then be fully deducted for federal tax purposes by the entity. The deduction is passed through in the distributive share of the PTE owners’ income. At the state level, the laws enacting these elective taxes usually allow the owner to:
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Claim a credit for the amount of the owner’s distributive share of the taxes paid by the PTE; or
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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 in late 2020 may have prompted even more states to enact elective PTE tax laws.
The Notice clarifies that partnerships and S corporations may deduct state income tax payments at the entity level. These payments are not taken into account:
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Separately under IRC Sections 702 or 1366 in determining the partner’s or shareholder’s own federal income tax liability; or
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in applying the $10,000 limit ($5,000 for married taxpayers filing separate returns) to 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 Enacted an Elective PTE Tax?
Nearly half of the states with a state income tax have enacted an elective PTE tax that allows owners to circumvent the SALT cap. Connecticut has a mandatory PTE tax. See the map below for a list of states that have enacted an optional pass-through entity tax.