The Rules Vary from State to State

Benjamin Buckner | Tax Manager

Pass-through entity tax elections have become a significant strategy in most U.S. states to mitigate the impact of the $10,000 cap on deductions of state and local taxes (SALT) on federal income tax returns.

The Tax Cuts and Jobs Act of 2017 (TCJA) limited the deduction for state and local taxes to $10,000 for individual taxpayers, which disproportionately affected residents of high-tax states such as California, New York and New Jersey. As a result, many taxpayers saw an increase in their federal tax liabilities, leading to political pressure on state governments to find ways to alleviate this burden.

In response, states started enacting legislation to allow pass-through entities, such as S corporations and partnerships, to elect a state-level tax on their income, rather than taxing the income at the individual owner level. This enabled businesses to deduct their state taxes at the entity level without running afoul of the $10,000 SALT deduction limit for individuals. 

The idea behind these new taxes is that the pass-through entity itself pays the tax, rather than the tax being paid by the pass-through owners. The pass-through entity will receive a federal deduction for state taxes paid.  The business owners in turn, receive a full “above the line” deduction instead of a potentially limited itemized deduction for state and local income taxes for their share of state income tax associated with the income of the pass-through.  

Connecticut was the first state to enact a pass-through entity tax (PTET) election law in 2018, and others followed quickly. To date, 36 states have enacted similar laws, all of which broadly follow the model of shifting deductibility of SALT taxes from the individual to the pass-through entity. The significance is that the pass-through entity is not subject to the $10,000 deduction limitation at the federal level. Moreover, these taxes are typically lower than personal income tax rates, making this option financially advantageous for businesses and their owners.

Besides the 36 states that have enacted PTET election laws, three additional states are considering similar laws. Of the remaining states, nine have no owner-level personal income tax on pass-through income, and two others have neither introduced nor passed legislation. 

The IRS in 2020 confirmed that it would respect PTET election laws, providing clarity and assurance to taxpayers and tax practitioners and accelerating the rate at which new states adopted them.

For state revenue purposes, the PTET regime is supposed to be revenue neutral, meaning the taxes collected at the entity level and credited to the owners are intended to be equal. Thus, states see PTET taxes as a win-win for their residents who can use these new tax regimes, because they generally won’t be restrained by the $10,000 SALT cap on any income earned by a pass-through business.

It’s important to note that state tax laws and regulations are subject to change, and the status of pass-through entity tax elections may evolve over time. Many states have built “kill switches” into their PTET election laws, meaning if the $10,000 deduction cap is ended at the federal level, the state PTET election laws will be automatically repealed.

Rules Vary from State to State

While many states have embraced the pass-through entity tax election approach, the specific rules and regulations vary from state to state. Some states offer a fixed tax rate, while others allow entities to choose their rates. Moreover, states differ in whether they allow all pass-through entities to make this election or if they have limitations based on entity type or income level.

The PTET is not a solution for all taxpayers. Some taxpayers who file in multiple states find that the tax credit for taxes paid to other states is more valuable than the reduction in federal taxable income. An analysis of the benefit is needed to ensure the most tax advantageous strategy is being pursued.

For many taxpayers with multi-state tax filing obligations, it may make sense to make the PTET election in one state but not in another, depending on various state rules. Key factors to consider in determining if you will utilize the PTET election include:

  • In some states, the PTET election is mandatory for owners, or is mandatory for certain types of taxpayers such as non-residents.
  • In other states, use of a composite return is mandatory.
  • States often have different rules regarding the PTET election depending on whether a non-resident filer has no other source of income in that state.
  • Certain states address tiered partnerships differently, with some factoring in the distributive amount of income to the PTET income.
  • In certain states, if taxes are paid at the entity level the credits are not passed through to the entity’s members. Since the tax is at the entity level, the credits remain at the entity level. This will be a key consideration in whether to make the PTET election.

Most Recent States to Enact PTE Election Laws

The most recent states to enact PTE election laws are Hawaii, Montana and Nebraska, all of which enacted them in 2023. Notably, Nebraska’s law is retroactive to 2018, enabling pass-through business owners to recapture state taxes paid back to the beginning of the TCJA.

The retroactive application of Nebraska’s law will not require prior returns to be amended. Instead of amending prior returns, pass-through entities will be able to voluntarily elect to pay prior year income taxes during 2023, 2024 or 2025, which will generate a federal income tax deduction for the year in which the prior-year’s taxes are paid. A pass-through entity’s payment of these taxes will also generate a refundable credit for its owners equal to their pro rata or distributive share of the Nebraska income tax paid by the electing pass-through entity.

The impact of Nebraska’s PTET law, while company-specific, is estimated to be potentially worth between $29 and $37 for every $100 of Nebraska business income taxes paid.

A Word About Quarterly Estimates

Quarterly estimated tax payments under PTET laws vary from state to state and it’s essential to know the rules.

For instance, Q4 estimates are due by December 15, 2023 in some states, and by January 15, 2024 in others.

Quarterly estimates in Iowa will be required for tax years beginning January 1, 2024, and for fiscal tax years beginning after May 11, 2023.

How We Can Help

If you would like to have a discussion about how PTET election laws may help you in the states where your pass-through entity does business, contact your Frost PLLC representative.