Unlocking Tax Savings with the Pass-Through Entity Tax (PTET) Election
Tax laws can be complex and sometimes result in significant financial challenges for taxpayers.
One such challenge that emerged with the Tax Cuts and Jobs Act of 2017 (TCJA) is the $10,000 cap on state and local income tax deductions, also known as the State and Local Tax (SALT) deduction. This limitation left many taxpayers feeling like they were losing out on substantial tax benefits.
Fortunately, there is a solution in the form of the Pass-Through Entity Tax (PTET) election. The Pass-Through Entity Tax election can help owners of a pass-through entity (PTE) in some states reduce their federal income tax burden and mitigate the impact of the SALT cap.
This article explains why the Pass-Through Entity Tax election is necessary, how it works, and how making this simple election can potentially save you thousands of dollars.
Understanding the SALT Cap
Before delving into the Pass-Through Entity Tax election, it’s crucial to understand the SALT cap. The TCJA introduced this limitation in 2018, capping the deduction for state and local income taxes at $10,000 for both individual taxpayers and married couples filing jointly.
This means that regardless of how much you pay in state and local taxes—including state and local income taxes or sales taxes, real estate taxes, and personal property taxes, you can only deduct up to $10,000 for federal income tax purposes.
The Impact of the SALT Cap
This cap can be particularly burdensome for taxpayers in high-tax states like California, Connecticut, Illinois, Hawaii, New York, New Jersey, and Vermont. Here’s how it impacts taxpayers.
- Reduced deductions. Taxpayers who pay more than $10,000 in state and local income taxes lose out on potential tax deductions. For example, say you pay $15,000 in state income taxes, $5,000 in property taxes, and $200 in personal property taxes when registering your vehicle. You can only deduct $10,000 on your personal income tax return, meaning you lose out on $10,200 of deductions.
- Higher federal tax liability. The inability to fully deduct state and local income taxes can lead to higher federal tax liabilities. In some cases, taxpayers who might benefit from itemizing if they were allowed to deduct all of their state and local taxes no longer benefit from itemizing and instead claim the standard deduction.
The Pass-Through Entity Tax Election: A Solution to the SALT Cap
Many states have devised a workaround known as the Pass-Through Entity Tax election to address the SALT cap limitation. This election allows pass-through entities, such as a partnership, S corporation, or limited liability company (LLC), to elect to pay taxes at the entity level rather than at the individual owner level.
In other words, the business pays state and local taxes on behalf of the business owners. This allows the business to fully deduct state and local income taxes as a business deduction rather than passing the deduction through to the owners, where it would be subject to a $10,000 cap.
Here’s how the Pass-Through Entity Tax election generally works:
Step 1: The Business Owner Makes the Election
Many states have a Pass-Through Entity Tax election form. Otherwise, your tax advisor can prepare the election for you. Have an authorized person sign the election and submit it to your state’s Department of Revenue or Franchise Tax Board. You may need to make a new election each tax year.
Keep in mind that a disregarded entity, such as a sole proprietorship or single-member LLC, is generally not eligible to make a PTET election.
Step 2: The Pass-Through Entity Makes Estimated Tax Payments
Instead of individual owners paying state income taxes, the pass-through entity itself makes estimated tax payments on behalf of its owners at the state level. These estimated tax payments generally need to be paid before the end of the tax year — December 31 for calendar year taxpayers.
Step 3: The Partnership or S Corporation Deducts the Tax Paid
The taxes paid by the pass-through entity at the state level are fully deductible at the federal level, even for taxpayers subject to the SALT cap.
Since the pass-through entity taxes are paid at the entity level, they are not subject to the $10,000 SALT cap. This allows taxpayers to fully offset their state income tax liability at the federal level, resulting in potential tax savings.
Keep in mind that the workaround rules vary from state to state. Some states offer a credit for taxes paid rather than a deduction. For example, in California, the entity pays a 9.3% levy on each owner’s share of net income at the entity level. Then, the entity owners can claim a PE Tax Credit equal to the 9.3% tax paid for state income tax purposes. Your tax advisor can help decipher your state’s rules for PTE taxes.
Benefits of the PTET Election
The Pass-Through Entity Tax election offers several benefits to owners of pass-through entities:
- SALT deduction maximization. Owners can maximize their SALT deductions by claiming them as deductible expenses on the S corporation or partnership tax returns, reducing their overall federal tax liability.
- Tax savings. Because the partnership or S corporation paid state income taxes at the entity level, the owner’s federal adjusted gross income (AGI) will be lower. Because many tax credits and deductions have caps based on AGI, this opens up the possibility for other deductions or higher-value deductions. In addition, by avoiding the SALT cap limitation, taxpayers can potentially save thousands of dollars in federal income taxes.
- Simplified reporting. Owners can benefit from simplified tax reporting, as the pass-through entity handles the payment and reporting of state income taxes.
States Adopting PTET Elections
According to the AICPA, as of November 2023, 36 states and one locality have enacted a Pass-Through Entity Tax. Those states are:
- Alabama
- Arkansas
- Arizona
- California
- Colorado
- Connecticut
- Hawaii
- Georgia
- Iowa
- Idaho
- Illinois
- Indiana
- Kansas
- Kentucky
- Louisiana
- Massachusetts
- Michigan
- Maryland
- Minnesota
- Missouri
- Mississippi
- Montana
- North Carolina
- Nebraska
- New Jersey
- New Mexico
- New York (and New York City)
- Ohio
- Oklahoma
- Oregon
- Rhode Island
- South Carolina
- Utah
- Virginia
- Wisconsin
- West Virginia
In some states, the workaround for pass-through entity taxes is effective for tax years beginning in 2021, while some are effective for the 2022 or 2023 tax year. Colorado and Nebraska made the pass-through entity tax workaround retroactive to 2018.
In addition, Maine, Pennsylvania, and Vermont have proposed pass-through entity tax bills in the works.
IRS Response to the PTE Tax Workaround
IRS Notice 2020-75 effectively permits states to adopt an entity-level tax workaround to the SALT cap deduction for owners of S corporations, partnerships, and limited liability companies.
However, the notice also indicated the IRS intends to issue further guidance and regulations.
In particular, tax professionals hope the IRS will allow investment partnerships to use the SALT cap workaround. Current IRS guidance doesn’t distinguish between taxes paid on different types of income, such as investment income versus business income. For that reason, we recommend that family offices organized as pass-through entities and investment partnerships exercise caution when electing to pay tax imposed at the entity level.
Should You Take Advantage of the Pass-Through Entity Tax Election?
The SALT cap limitation has posed challenges for many taxpayers, especially those in high-tax states. However, the Pass-Through Entity Tax election provides a viable solution to maximize deductions and reduce federal tax liabilities.
If your state allows it, electing entity-level income tax payments can help you potentially save thousands of dollars and simplify your tax reporting.
However, due to varying rules on the pass-through entity tax election from state to state and unclear eligibility guidance from the IRS, it’s essential to consult with a tax professional familiar with your state’s tax laws to understand the requirements and benefits in your jurisdiction.
Plus, the PTE tax election could become obsolete in a few years. The TCJA only capped state and local taxes for the 2018 through 2025 tax years. Without further action from Congress, the cap will expire after 2025.
If you would like to learn more about making a pass-through entity tax election, estimate how much such an election could reduce your taxable income, or make the annual election, schedule a free consultation with Hood & Associates. We can analyze your specific circumstances and help you make the best decision for federal income tax purposes.