March 28, 2023
Patrick Lawler - RSM US, LLP - [email protected]
Jacob Seitz - Andersen - [email protected]
As many taxpayers are already aware, the Tax Cuts and Jobs Act introduced the $10,000 state and local tax (“SALT cap”) deduction limitation for individual, trust, and estate filers. In response, states were quick to establish “workarounds” in the form of pass-through entity (“PTE”) level taxes (generally assessed against a Partnership or S-Corp). Connecticut became the first state to respond, enacting a mandatory PTE level tax applicable for the 2018 tax year. The IRS released Notice 2020-75, which provides that both elective and mandatory state entity level income tax laws will be respected for purposes of allowing the full deduction for PTE level tax payments made on or after November 9, 2020. Since this first enactment, many states have established their own elective PTE level taxes. To date, 32 jurisdictions (31 states and 1 locality) have enacted PTE level taxes, leaving 11 states with an owner-level personal income tax (as of March 25, 2023, 4 of these 11 states have proposed PTE bills).
These workarounds provide significant opportunities for taxpayers looking to mitigate the impact of the SALT cap. Though the common theme among these states is to combat the SALT deduction limitation, each use varying methodologies, including differing requirements and limitations for both PTE and individual taxpayers. The following focuses on several areas to watch for when considering elections in the various jurisdictions.
Timing of Elections and Payments
One of the most important considerations when considering PTE level tax elections is to understand when elections and payments are due. While many states require the election to be made on the pass-through entity’s income tax return (either original or extended due date), there are a few notable exceptions. The state of Utah, which enacted a PTE workaround effective for the 2022 tax year, requires taxpayers to make such election before the last day of the PTE’s taxable year. The state of New York imposed a similar requirement with elections due no later than March 15th of the tax year for which the election is effective (i.e., March 15th, 2023 due date for the 2023 PTE level tax election). Though many states may agree on when elections must be made, some differ in terms of when payments are required. For example, California requires a timely estimated tax payment by June 15th of the tax year ($1,000 or 50% of the elective tax paid in prior period, whichever is greater). Even in situations where elections and/or payments are not due until extensions/returns are filed, taxpayers should consider the impact of federal deductibility for payments made after year-end.
Election Considerations
Understanding when elections and payments are due is just a small component in the decision-making process. Taxpayers should also consider the implications of making a PTE tax election which can vary by state. For instance, states like Alabama, Louisiana and Oklahoma require one-time elections, with these remaining in effect until revoked. This could result in unintended consequences for PTEs with frequent owner changes or partner residency changes, forcing taxpayers to proactively consider the future benefits/risks of having such elections in place. Taxpayers must also be aware of the various restrictions imposed by these states – this includes restrictions not only on the PTEs ability to make such elections, but also the eligibility to participate based on the character of owners involved. States like North Carolina and Oregon, for example, require PTEs to be 100% owned by only individuals, trusts or estates. Other states impose restrictions on the owners eligible for inclusion in such PTE level tax calculations, with some only allowing individual owners (i.e., Arizona) or excluding specific owner types like C-Corporations (i.e., Colorado – if unitary with the PTE). With the various limitations put on taxpayers making these elections, it is important for taxpayers to understand how every owner would be impacted – with some states requiring majority owner consent, one negatively impacted owner could make the difference in pursuing such elections.
Credit Limitations
Having now determined when elections/payments are due and confirming your entity and owners are eligible to make an election – was it all worth it? Unfortunately, the next hurdle is also one of the most challenging – will everyone benefit from the election? It’s important to note that in many situations, not all owners will benefit from these PTE level tax elections. With these elections still being relatively new, not all states have commented on how such taxes will be treated for resident credit calculations. As a result, some nonresident owners may not receive a credit on their resident tax return for these taxes, resulting in higher liability on their individual returns. Taxpayers should also be cautious of state-imposed credit limitations – this is the case in states like Massachusetts that limit the credit amount for qualified members (90% limitation), as well in states like Pennsylvania that restrict which credits can be claimed (credit can be claimed for those reported through S-Corporations, not partnerships). Not all states allow for the credit to be refunded, providing a carry forward period for utilization which may result in credits going unused (i.e., Arizona & California provide a 5 year carry forward of the PTE credit). Unless properly vetted, taxpayers and owners may find that the additional tax/burden associated with these limitations far outweigh any expected benefit from the SALT cap workaround.
Takeaways
With the $10,000 SALT cap in effect through at least 2025, state PTE level taxes are here to stay for the foreseeable future. As states continue to evolve and expand these workarounds, it is essential for taxpayers to understand how each differs in terms of applicability/limitations/etc. Detailed analysis is necessary to evaluate not only the benefits, but also the risks associated with these workarounds. Otherwise, taxpayers may find themselves “working around” the clock to fix unintended consequences.
Disclaimer: This article is designed to provide information in regard to the subject matter and has been prepared with the understanding that neither the Illinois CPA Society nor the author of this article is providing accounting, tax or legal advice or is performing any legal, accounting or other professional service. If accounting, tax or legal advice or other expert assistance is required, the services of a competent professional person should be sought.