One of the modifications to the Internal Revenue Code achieved by the Tax Cuts and Jobs Act (2017) was to restrict the amount of state and local taxes deductible as itemized deductions for individual income taxpayers. The limit was placed at $10,000 and included amounts paid for state and municipal income taxes, property taxes, and sales taxes. The limit struck a major blow to states’ revenue departments as income taxes paid to the states were largely no longer useful in reducing federal tax burdens of residents. Individual state income taxes became more of a burden on taxpayers and less of a transfer from federal income tax paid to state income tax paid.
At full tilt, states began looking for workarounds to enable their income taxes to be useful to residents in reducing federal income tax burdens. The solution that many states have now settled on is an election for pass-through entities—which generally includes businesses filing federally as partnerships and S corporations—to pay tax at the entity level, similar to a C corp. If the election is made, then the state income tax burden to the individual will be borne by the business they own, allowing the tax to be deductible on the business’s federal income tax return. The tax paid is deductible as “taxes and licenses” paid by the business, reducing ordinary income and ultimately the amount of income reported from the business by the individual on their federal income tax return.
States vary in many of the specifics of how the pass-through entity tax election works, including the character of shareholders that are eligible to make the election, whether out-of-state shareholders are required to file individual income tax returns if the election is made, and when and how the election must be made, but the elections are similar across states. In general, the elections have a negligible effect on the amount of state income tax paid, but the elections have been shown to produce material tax savings at the federal level.
On July 1, 2022, Missouri Gov. Mike Parson signed House Bill 2400 (2022) into law. This law establishes a pass-through entity tax election for the state that goes into effect for fiscal years ending on or after December 31, 2022 and does not have an expiration date. The election is made annually on the state return filed by an S corp or partnership. All shareholders are eligible to be included in the election to have tax paid at the entity level on their behalf, and any entity that is taxed as an S corp or partnership for federal income tax purposes is eligible to make the election, including limited liability companies.
The tax rate will be a flat rate of 5.4%, the highest marginal rate in the state of Missouri. The bill states that the tax will be calculated by multiplying the Missouri apportioned sum of separately and nonseparately stated income, the deduction for qualified business income calculated under the rules for Internal Revenue Code Section 199A, and any increasing or decreasing modifications permitted under Missouri law, by the tax rate. Electing shareholders may claim a credit against income tax in the amount of their pro rata share of pass-through entity tax paid by the business on their behalf.
The bill places responsibility on the business to report the amount of pass-through entity tax credit available to all electing shareholders. If the credit reported to a shareholder exceeds the amount of tax shown on their tax return, the overpayment may not be refunded but may be carried forward to future years. A nonresident electing shareholder who is an individual whose only income from Missouri sources is their distributive share of income from an electing pass-through entity is not required to file a separate Missouri return. The bill includes a section detailing requirements for electing businesses to designate a representative for the entity in regard to the election. The bill leaves latitude for the Department of Revenue to determine “reasonable qualifications and procedures for designating a person to be the affected business entity representative.” We will have to wait for the department to produce rules and procedures for designating an election representative.
An additional point of consideration is that the credit available to taxpayers will be equal to 95% of the pro rata tax paid on their behalf by the pass-through entity. The 5% difference between the total amount of pass-through entity tax paid on a taxpayer’s behalf and the amount available as a credit will serve as an additional surtax on business owners in exchange for the benefit of tax savings at the federal level provided by the election.
This new legislation represents a significant tax-saving opportunity for many business owners who file Missouri income tax returns and pay tax to the state. Tax paid to the state of Missouri under a pass-through entity tax election will be deductible at the federal level on Form 1065 or 1120(S), reducing ordinary income and ultimately the amount of federal income tax paid by the shareholder. If no election is made, then tax paid to the state will provide no benefit to shareholders at the federal level. An additional benefit is the reduction in compliance obligations through the removal of the requirement to file individual tax returns for nonresident trusts and individuals. All businesses operating in Missouri should consider whether the election is beneficial to them or their shareholders.
For additional guidance on Missouri income tax law, please reach out to a professional at FORVIS or submit the Contact Us form below.