Many high-income taxpayers were negatively impacted when the Tax
Cuts and Jobs Act of 2017 (TCJA) imposed a $10,000 limit on the
individual federal income tax deduction for state and local taxes
(SALT). This $10,000 limit is often referred to as the “SALT
cap.” In response, over two dozen states and one locality, New
York City, have since implemented pass-through entity taxes (PTETs)
that provide a workaround for those eligible.
PTET approach
The SALT cap has proven especially painful for owners, members
and shareholders in pass-through entities (S corporations and
partnerships). These taxpayers historically have seen their
entities’ state-level tax expenses “flow through” to
them individually and took advantage of deducting the state tax
owed as an itemized deduction on their individual returns without a
cap. With TCJA’s enactment of the $10,000 SALT cap, many
high-income taxpayers lost the benefit of deducting the full amount
of individual state taxes paid on their flow-through income.
PTETs take advantage of the fact that the SALT cap applies only
to individuals, not businesses. The particulars of the various
PTETs vary by jurisdiction (see Sidebar, “California, New York
Laws Illustrate the Differences,” below), but they generally
allow covered pass-through entities to pay a mandatory or elective
entity-level state tax on business income. The entity is then
permitted to deduct the full amount of the PTET as a business
expense, thereby circumventing the SALT cap in effect at the
individual level. The benefit is passed on to the individual
owner(s) in the form of a full or partial state tax credit,
deduction or income exclusion.
Related Read: Making the Most of the New Pass-Through
Deduction
IRS response
PTETs are not the first workaround to surface at the state level
to circumvent the SALT cap. Earlier strategies quickly failed,
though, as they were shot down by the IRS. For example, the agency
explicitly rejected initiatives in states like New York and New
Jersey to allow taxpayers to donate to state-sponsored charitable
funds in exchange for credits against their state taxes.
To the surprise of some, the IRS gave its approval for state
PTET elections in 2020 in IRS Notice 2020-75. It clarified that
SALTs imposed on the income of partnerships or S corporations are
deductible by the entity and not subject to the SALT limit for
partners and shareholders who itemize their deductions. The IRS has
indicated it intends to issue proposed regulations with further
guidance, but such regulations had not been published at the time
this article was drafted.
Next steps
Many law firms are well positioned to take advantage of the PTET
approach but will need to do some planning. States, for example,
have deadlines for when an entity must make its annual election and
in some states the election is irrevocable. In addition, consent
forms must be obtained from owners, members and shareholders (or at
least notice must be given to them) to make the election.
It is also worth considering that the election will not
necessarily help every owner; in fact, it could be detrimental to
some. An attorney might, for instance, live in a state that does
not allow credits for PTET paid in another state, which would
reduce the election’s benefit – and create a double-taxation
situation for the attorney.
Law firms considering this option should consider where the
owners, members or shareholders live and their other income
sources, as both of these factors could affect how an election
plays out. Evading the SALT limit may not prove worth it in light
of other effects on federal and state tax liabilities.
Promising but complex
Variations among the state PTETs abound, with differences in
everything from eligible entities and how individual taxpayers are
credited to election requirements and deadlines. Contact your ORBA
advisor to be certain you both minimize your tax liability and
comply with all of the applicable requirements.
Related Read: Illinois 2022 Budget to Raise New Tax
Revenue
Sidebar: California, New York laws illustrate the
differences
The PTET laws in California and New York provide examples of the
potential variations in various states’ PTET laws. While both
generally allow a pass-through entity to pay tax at the entity
level with a corresponding credit at the individual tax level,
significant differences exist.
For example, California’s PTET is applied to income which
includes only the distributive shares of those partners, members or
shareholders who consent to the election. In New York, however, the
PTET income includes the income of all partners, members, or
shareholders, regardless of whether they consent. The pass-through
entity income calculation also differs between partnerships and S
corporations in New York.
The California credit is nonrefundable, but can be carried over
up to five years. Therefore, if a taxpayer overpays California tax
in one year and does not have enough California tax liability in
subsequent years, the overpayment/credit will be lost forever. In
New York, the excess credit over tax due is treated as an
overpayment and credited or refunded.
These are just a few of the differences between the two
states’ approaches to PTETs. Other states will have even more
variations. Therefore, it is imperative to perform a comprehensive
analysis of the effects of a PTET election at all levels of
taxation before taking the leap.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.