Can Your Pass-Through Entity Benefit from Pass-Through Entity Tax?

Let’s face it: Navigating taxes got a bit more complicated after the Tax Cuts and Jobs Act (TCJA) in 2017, especially with that pesky $10,000 limit on state and local tax deductions. But here’s some good news for business owners: a bunch of states have rolled out something called the pass-through entity tax (PTET). This clever workaround is helping many folks in high-tax states breathe a little easier when it comes to dealing with the SALT cap.

This cap created a disadvantage for taxpayers in high-tax states, including California, New Jersey, and New York State. In some cases, taxpayers in these states lost thousands of dollars in potential tax deductions.

For example, according to an analysis from the Pew Charitable Trust, before the SALT deduction cap, New York taxpayers claimed an average of $22,169 in state and local taxes on their personal income tax returns. Capping their write-off at $10,000 means the average New Yorker loses out on more than $12,000 in tax deductions each year.

The good news for owners of pass-through entities is that many states have created a workaround to the federal SALT cap in the form of a pass-through entity tax.

What is the SALT cap workaround?

The workaround rules vary from state to state, but the end result is the same—reducing a pass-through entity (PTE) owner’s state income taxes.

Here’s how it generally works:

  1. PTEs have the option (or are required) to pay state and local taxes at the entity level.
  2. Individual PTE owners, who would’ve had their SALT deduction capped at $10,000, benefit by having their share of PTE income lowered by the taxes paid by the business.

However, some states offer a credit for taxes paid instead of a deduction on entity-level taxes.

For example, in California, the company pays a 9.3% levy on each owner’s share of the business’s net income. The PTE owners can then claim a credit on their California personal income tax return equal to the 9.3% tax.

Who qualifies for the SALT cap workaround?

These workarounds are only available to owners of pass-through businesses, including partnerships, some limited liability companies (LLCs), and S corporations. Sole proprietorships, single-member LLCs, and wage earning taxpayers can’t take advantage of the tax strategy. C corporations also can’t use the workaround since they’re not pass-through entities.

Also, this strategy is only available in states that have enacted PTE tax workaround legislation.

Fortunately, the list of states allowing (or mandating) an entity-level tax on PTEs is pretty extensive:

  1. Alabama
  2. Arizona
  3. Arkansas
  4. California
  5. Colorado
  6. Connecticut
  7. Georgia
  8. Hawaii
  9. Iowa
  10. Idaho
  11. Illinois
  12. Indiana
  13. Kansas
  14. Kentucky
  15. Louisiana
  16. Maryland
  17. Massachusetts
  18. Michigan
  19. Minnesota
  20. Mississippi
  21. Missouri
  22. Montana
  23. Nebraska
  24. New Jersey
  25. New Mexico
  26. New York
  27. New York City
  28. North Carolina
  29. Ohio
  30. Oklahoma
  31. Oregon
  32. Rhode Island
  33. South Carolina
  34. Utah
  35. Virginia
  36. West Virginia
  37. Wisconsin

Lawmakers in Maine, Pennsylvania and Vermont are also working on SALT deduction cap workaround legislation.

How to use the SALT pass-through workaround for federal income tax purposes

Most states with a PTE tax deduction allow the business to make an annual election by a specific deadline. The business may also have to provide notice to the PTE owners or get their consent before making the election.

How does the IRS view this strategy?

In November 2020, IRS Notice 2020-75 effectively permitted states to adopt a workaround to the federal deduction cap for pass-through business owners.

However, the notice also indicated that the IRS intends to issue further regulations. In particular, we hope to see guidance on whether investment partnerships can use the SALT cap workaround.

Currently, IRS guidance doesn’t distinguish between PTE tax paid on different types of income, such as business income versus investment income. For that reason, family offices organized as pass-through entities and investment partnerships should exercise caution.

However, it could become a moot point in a few years. The TCJA only applied the cap on state and local taxes to tax years 2018 to 2025. While many members of Congress have indicated that they want to increase the cap, they haven’t finalized legislation. So the cap will expire after 2025 without action.

Should you take advantage of the SALT tax workaround?

Under the right circumstances and in the right jurisdictions, the workaround can be a powerful way to reduce your income tax liability. But before pursuing the workaround, it’s crucial to consider where individual owners of the business pay taxes. Depending on where owners file state taxes, the election could benefit some owners while resulting in others paying more state taxes.

If you need help deciding whether this is the best strategy for your business based on your unique facts and circumstances, please reach out. We’d love to help you crunch the numbers.

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