There is a growing trend this year among states implementing a Pass-Through-Entity (PTE) Level Tax. The primary reason for this is due to the limitation on the state and local tax deduction for individuals. Under the TCJA an individual is allowed to deduct only a maximum of $10,000 in personal state and local taxes (SALT) including state income taxes, real estate property, and auto excise tax paid.
The PTE tax is a work-around to this $10k SALT limitation. The IRS has recently released guidance that the state and local income taxes paid by a partnership or S Corporation (NOT Schedule C Sole Proprietors), are allowed as a deduction in the computing of the entity’s net income or loss for the year. There is no requirement for individual partners or shareholders to add this back to their reported income. The PTE tax shifts the direct burden of taxation from the owners to the entity itself.
Currently, eighteen states have enacted PTE level tax: AL, AR, AZ, CA, CO, CT, GA, ID, IL, LA, MD, MN, NJ, NY, OK, RI, SC, & WI. An additional five states (Massachusetts, Michigan, North Carolina, Ohio & Pennsylvania) have currently pending PTE legislation. CT is the only one that is mandatory. For all other states, the PTE level tax is elective and different fact patterns impact the analyses on whether making this election is beneficial for the owner or not.
Each state may have their own specific rules but in general there are two types of PTE Tax Regime Structures:
Type 1 States: require electing PTE’s to calculate taxable income and pay the state income tax. The PTE owner does NOT have to include their distributive share of income or loss on their personal income tax return in those specific states meaning they won’t have to file a personal state tax return because they made the PTE election. CO, LA, OK, and WI currently have this structure set up.
Type 2 States: require electing PTE’s to calculate taxable income and pay the state income tax. The difference from a Type 1 state is that the pass-thru nature of the state tax payments continues which means a state taxable income and potential state tax credits would flow to the owners and be reported on their personal state income tax returns. All other states mentioned above fall under this structure. Massachusetts pending legislation also seems to follow this structure.
The key items to analyze when determining if the election makes sense are:
- Resident State Credits – does the individual’s resident state allow a credit for PTE taxes paid? You could be forfeiting a state level credit for a Federal deduction. Depending on whether you are in a high or low taxed state may impact the decision to elect PTE tax or not.
- Shareholder or Partner type of entity – does the PTE Deduction impact the corporate partner in the same way it does the individual partner? The answer is no and careful consideration needs to be made before a PTE elects into this tax regime for all owners.
The above considerations will impact partnerships and S corporations when filing their 2021 tax returns. You should consult your tax advisor to see which option may be best for your partnership or S Corporation.
Yolanda Rego, CPA, is a Tax Manager at Katz, Nannis + Solomon, P.C. If you have any questions or would like to speak with one of our tax professionals, please contact our office at 781-453-8700.