Federal issues surrounding state pass-through entity tax regimes

Overview

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.

PTET mechanics, prevalence

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.

Important considerations

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):

• The applications of the rules vary widely by state. While most regimes are elective, Connecticut’s, for example, is mandatory. Some states require the election be made prior to the end of the applicable tax year, while others don’t allow it to be made until after year-end.
• Is the state’s PTE election irrevocable? If so, it could create an unnecessary compliance burden upon the expiration of the SALT cap (currently set for Dec. 31, 2025) as additional filings, estimated payments and other planning may be required of the PTE, but not carry any associated benefit as the SALT cap would no longer be in place at the individual level.
• Do the owners’ resident states allow credits for PTET paid to other states? If not, an owner’s distributive share of the PTET can effectively become taxable, as most states require payments to other jurisdictions be “added back” in determining state taxable income.

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.

Outstanding federal tax issues

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:

• Confirmation of the treatment of PTET payments made by PTEs engaged in investment activities. Notice 2020-75 specifically provides for PTET payments to be deducted from trade or business income. As such, it is unclear how an entity not engaged in a trade or business should report these payments.
• Confirmation of whether deductions for PTET payments should be considered passive or nonpassive at the owner level. Intuitively, this would simply be dictated by the owner’s level of participation in the PTE’s activity(ies); however, passive activity loss regulations specifically provide that deductions for SALT payments are nonpassive in character. To the extent that a PTE has passive owners, this conflict can place additional reporting burdens on the PTE.
• Interaction with S corporation rules. To remain an S corporation, federal rules require the corporation make distributions and allocate all tax items to its shareholders, based on their pro rata share of stock ownership. If an S corporation makes a PTE election in a state where some shareholders do not wish or are ineligible to participate, adhering to the pro rata ownership rules for distributions and allocations of the PTET payment deduction would create inequities among the owners.

Future of the SALT cap

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.