State and local tax planning seems to be in a never-ending world of flux. As soon as one issue appears to be somewhat settled, another area of complexity comes into being. Two such areas, pass-through entity tax elections and the Supreme Court’s Wayfair decision are cases in point. With the $10,000 cap on the state and local tax (SALT) deduction enacted as part of the Tax Cuts and Jobs Act of 2017 (TCJA), more and more states have enacted workarounds in an effort to circumvent the limitation. On the other hand, Wayfair was decided four years ago, with many believing the issue of economic nexus for sales tax purposes appeared to be settled. However, the Multistate Tax Commission (MTC) revised its Statement of Information Concerning Practices of Multistate Tax Commission and Signatory States, calling into question how broadly Wayfair and P.L. 86-272 can be applied to the taxation of different internet transactions.
During 2022, approximately 12 additional states enacted a pass-through entity tax (PTET) election which brings the total number of states to 29 plus New York City. As a reminder, the PTET elections are in response to the SALT deduction limitation which was enacted under the TCJA legislation. Currently, individual taxpayers are only allowed a maximum deduction of $10,000 on federal Schedule A for all state taxes paid.
The following states (and New York City) currently have a PTET election: Alabama, Arizona, Arkansas, California, Colorado, Connecticut, Georgia, Idaho, Illinois, Kansas, Louisiana, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, New Jersey, New Mexico, New York, North Carolina, Ohio, Oklahoma, Oregon, Rhode Island, South Carolina, Utah, Virginia and Wisconsin.
The PTET allows the entity to pay state taxes and deduct them for federal income tax purposes thus reducing the overall federal tax liability. However, the formula is not as simplistic on the state side of these elections. Careful analysis of owners’ tax attributes, the mechanics of calculating the PTET liability and limitations for taking credit for other state taxes paid, including the PTET as well as other implications to the owners’ state income tax filings, must be completed. When owners of a pass-through entity are residents of different states, the outcome of these elections can produce both winners and losers, meaning some may pay more tax while others less. How an entity resolves the tax differences that may occur among its owners with these elections needs to be addressed proactively. Careful consideration should also be given to S corporations; an unintended consequence of these elections could result in a second class of stock thus invalidating the federal S corporation election. Partnership agreements should be reviewed to ensure they address the tax differences that can result between its partners.
All but Connecticut’s PTET are elective. Most are irrevocable once made. Many elections expire in 2026 when the SALT cap deduction is lifted under the original law of TCJA. The requirements for making a valid PTE election and adherence to estimated tax payments must be observed as the rules vary by state. For example, failure to make a payment by June 15 can bar a taxpayer from making a valid election in California when the entity files its return. New York’s election is required to be made by Sept. 15 of the tax year for which it applies and must be made via the state’s online tax portal.
Each state has determined what type of entity can make the election as well as who is a qualified member. In some states, a C or S corporate partner will prevent the entity from making election and in others it will not.
In the majority of the PTET states, the owner reports both the income and the tax paid at the entity level on their personal income tax return. If the pass-through entity is a multistate business, the owner most likely pays income taxes to other states. The ordering rules may require the owner to use credit for taxes paid to other states prior to claiming the credit for taxes paid by the pass-through entity. In California, the PTET is not refundable and currently only allowed to be carried forward through to the 2026 tax years.
While these can be great regimes for reducing overall tax liabilities, the importance of analyzing the implications of these elections on the owners’ overall income tax posture prior to making election(s) is paramount to avoid or prevent adverse tax consequences.
It's been four years since the U.S Supreme Court ruled in South Dakota v. Wayfair, Inc. (Wayfair) that South Dakota’s economic nexus for sales tax purposes was valid. Currently, all 46 jurisdictions that impose a sales tax have economic nexus. In 1959, Congress enacted Federal Public Law 86-272 (P.L. 86-272) to prevent states from imposing an income tax when the company’s activities are limited to soliciting sales of tangible property for which the order is approved outside the state of destination and the goods are shipped from a point outside of destination state. The actual language of P.L. 86-272 is stated below.
No State, or political subdivision thereof, shall have power to impose, for any taxable year ending after the date of the enactment of this Act, a net income tax on the income derived within such State by any person from interstate commerce if the only business activities within such State by or on behalf of such person during such taxable year are either, or both, of the following: (1) the solicitation of orders by such person, or his representative, in such State for sales of tangible personal property, which orders are sent outside the State for approval or rejection, and, if approved, are filled by shipment or delivery from a point outside the State; and (2) the solicitation of orders by such person, or his representative, in such State in the name of or for the benefit of a prospective customer of such person, if orders by such customer to such person to enable such customer to fill orders resulting from such solicitation are orders described in paragraph (1)
It’s important to emphasize P.L. 86-272 doesn’t apply to any other state tax but income taxes and doesn’t apply to any company that sells intangible licenses or provides services, like repairs, installation etc. The renting or leasing of tangible property, while it may be tangible property, also is outside of the P.L. 86-272 protection. Lastly, it’s important to note, the language of P.L. 86-272 does not actually include anything about having physical presence in the state. This is an important distinction to point out as this law was written in 1959 when one can assume the authors had no vision of the internet and the magnitude of e-commerce.
The last U.S. Supreme Court case to interpret P.L. 86-272 was Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214 (1992). This decision clarified a bit about what solicitation is and is not. Activity, explicitly or implicitly, to invite an order is generally considered to be solicitation and therefore within the boundaries of P.L. 86-272. The decision also provided guidance to indicate activities that are “entirely ancillary” to solicitation are those that serve no business function apart from their connection to solicitation such as providing sales personnel with free samples or a vehicle for travel and thus if performed in a state will not lose P.L. 86-272 protection. However, it does not include activities that may be assigned to sales personnel such as resolving disputes with the customer or replacing stock goods (the list is not all inclusive). Another way to view this is any activity generally occurring after a sale has taken place is not within the boundaries of P.L. 86-272 and thus may create an income tax liability.
As with most things, state and local tax is in a constant state of motion and subject to change. The MTC, an intergovernmental state tax agency whose “mission is to promote uniform and consistent tax policy and administration …” approved in August 2021, its update to its Statement of Information Concerning Practices of Multistate Tax Commission and Signatory States under Public Law 86-272 (Statement). While the Wayfair decision did not address P.L. 86-272, the MTC workgroup proactively addressed through this update how business activities conducted through the internet impact the application of P.L. 86-272.
As stated above, back in 1959, when P.L.86-272 was enacted, it did not mention physical presence. Today, businesses have websites, instead of brick-and-mortar stores and many offer the ability to purchase from these sites which under Wayfair may cause them to be remote sellers. Numerous sellers use marketplace facilitator sites such as Amazon and eBay to reach consumers. When one visits a seller’s website, the user can accept cookies or at least modify what the cookie captures from the user’s experience. No computer handy, no problem, we can download an app to our phone for our favorite retailers. In the MTC’s Statement, it has identified 11 additional scenarios in which tangible personal property is purchased via the internet and whether the activity is afforded the protection from income taxation under P.L. 86-272 or not. In each of these examples, the sale involves only tangible property, unless specifically noted otherwise. The orders are accepted or rejected and shipped from a state other than the destination state and the seller has no other contact with the consumer’s state. If there is uncertainty about the details of how customers are interacting with website or what data is captured from cookies, now would be the time to find out.
The 11 scenarios per the Statement are as follows.
The reaction to the MTC’s updated Statement has been varied certainly by SALT practitioners and taxpayers alike. One thing most agree on is that conducting business via the internet is here to stay. Whether that means a state can impose its income tax on such seller because it falls outside of P.L. 86-272 protection may need to be decided by the courts. It’s up to the states to either adopt the MTC’s Statement or develop their own guidance like California and New York. And if one thought Wayfair settled the question of economic nexus for sales tax purposes, Pennsylvania recently ruled that an out-of-state seller, whose only activity in the state was sales through a marketplace facilitator, did not have nexus for sales nor income taxes even if the seller had inventory in the state. We expect this case to be further litigated.
When it comes to managing a company’s state and local tax liabilities, its generally best to do so in a proactive manner such that it allows the company to make informed business decisions.
For more information on this topic, contact our team.
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.