The Tax Cuts and Jobs Act (TCJA) imposed a $10,000 limit ($5,000 for married taxpayers filing separately) on individual taxpayers’ itemized deductions for state and local tax (SALT) payments for the 2018 through 2025 tax years. In response, legislatures of states with high individual income tax rates began introducing pass-through entity tax (PTET) regimes in 2018, to circumvent the limit at the individual level. By allowing partnerships and S corporations to make an election that would subject them to an entity-level state income tax, a PTET regime shifts the deduction from the individual level, where it would be subject to the SALT cap, to the entity level, where it can likely be deducted in full.
Speculation ensued over whether the IRS would respect these arrangements for federal purposes or invalidate them on the grounds they were abusive, in place solely to avoid the statutory SALT cap. Finally, in November 2020, the IRS released Notice 2020-75 (Notice) announcing its intent to issue proposed regulations addressing the treatment of such payments. In advance of the proposed regulations, the Notice permits pass-through entities to deduct “specified income tax payments” in computing their federal non-separately stated income or loss). While welcome news to taxpayers and practitioners, the Notice left many questions unanswered, and to date the proposed regulations have not been released, nor has any further guidance.
The defining characteristic of a pass-through entity (PTE), for tax purposes, is how it “passes” its income through to its owners to be taxed on their respective returns, rather than at the entity level. This is generally true for both federal and state purposes. An owner would thus pay both federal and state tax on their distributive share of the PTE’s income. Prior to the TCJA, the PTE owner could claim a federal itemized deduction for the full amount of state taxes paid (unless the taxpayer’s income was high enough to subject them to limitations on the total amount of itemized deductions they could claim or was subject to the alternative minimum tax).
A state adopting a PTET regime provides PTE owners a workaround to the SALT cap as follows: Electing PTEs pay state income tax at the entity level, which the PTE may then deduct without limitation. The allowable PTET deduction reduces the PTE’s reportable federal taxable income; in turn, the PTE’s owners’ distributive share of federal taxable income will be lower due to the deduction of the PTET. This effectively creates the benefit of a state income tax deduction for PTE owners. Lastly, the state typically provides for the owner either to receive a credit against their state tax liability in the amount of their share of the PTET, or their state adjusted gross income to be reduced by their share of the PTET, preventing the income from being taxed by the state twice.
In the years following their introduction, the majority of states have followed suit in enacting PTET legislation; 29 states currently have regimes in place. Nine states do not impose any owner-level taxes on PTE income, leaving 12 states that tax PTE income exclusively at the partner or shareholder level. Note, however, that three of the remaining 12 states have proposed legislation that would install an entity-level tax, if enacted.
While on the surface it would seem apparent that owners have much to gain if their PTE elects to be subject to a PTET regime, there are many complicating factors to consider. In addition to the open federal items discussed below, state-related concerns include, but are not limited to (see the SALT article for additional discussion):
Generally, the only straightforward instance involves a PTE with a filing requirement solely in its resident state, of which all of its owners are also residents. This is not to suggest that this is the only scenario in which making the election is beneficial; however, in all cases, a careful cost/benefit analysis must be conducted before a decision is reached.
As the release of Notice 2020-75 approaches its two-year anniversary, it remains the only guidance from the IRS on the federal treatment of PTET payments. Further, there have been no indications from the IRS regarding the timing of the release of the proposed regulations the Notice announced. Among several others, open issues include:
The limitation under current law will expire after the 2025 tax year. However, there is a faction of Democratic lawmakers from both chambers of Congress (known as the SALT Caucus) that have banded to make repealing the cap a top priority and have previously threatened to vote against any legislative iteration of President Joe Biden’s agenda that did not eliminate or provide some form of relief from the limitation. While they ultimately backed off of this ultimatum to ensure passage of the Inflation Reduction Act, the group remains active and could continue to influence future proposed legislation depending on the results of the midterm elections.
Alternatively, many Republicans support extension of the TJCA’s individual provisions past their sunset dates (most expire after Dec. 31, 2025), including the SALT cap. Recently, several Republican lawmakers introduced the TCJA Permanency Act, which, if enacted, would make the SALT cap permanent at the current level of $10,000 ($5,000 for married taxpayers filing separately).
We encourage you to reach out to your Baker Tilly advisor regarding how any of the above may impact your tax situation.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.