A major component of the 2017 Tax Cuts and Jobs Act (TCJA) was the $10,000 limit on the state tax deduction (SALT Cap) for individual income tax return purposes. Since the TCJA’s passing, states have been looking for workarounds to provide income tax relief for individuals. The IRS disallowed many of the state workarounds that have been proposed but approved the pass-through entity-level tax election (PTE) with the release of Notice 2020-75.
The state PTE works because the SALT Cap is applicable for only individual income tax purposes. For the state PTE, pass-through entity taxpayers, such as partnerships and S corporations, can elect to pay state income taxes at the entity-level return rather than on the personal income tax returns of the individual partners and owners.
As of September 1, 2021, 19 states have passed a PTE:
- New Jersey
- New York
- Rhode Island
- South Carolina
It should be noted the PTE effective date is the 2022 tax year for the following states: Arkansas, Arizona, Colorado, Georgia, and Illinois.
While the specific requirements and applicability for each state’s PTE can vary, the overall effect of the election is the same. By imposing an income tax directly on the pass-through entity, which is not limited in the amount of state taxes that it can deduct for federal income tax purposes, state tax on pass-through entity income now becomes a deduction for the pass-through entity for federal income tax purposes.
The benefit of the state PTE can alleviate the SALT Cap from an individual income tax perspective. However, there are questions and issues that should be considered before a taxpayer makes a PTE election in any state.
First, a taxpayer must consider if the election is made on an annual basis or irrevocable once made. If the election is irrevocable, a state will generally require the taxpayer to submit a request as to the reason why the taxpayer would like to change its filing methodology, and approval to change can be a challenge to win in certain states.
Next, a taxpayer needs to consider the mechanics of how the state PTE will affect its individual income tax return. Some states have maintained that the individual owners of the pass-through taxpayer using a PTE can claim an income tax credit for their share of the pass-through entity tax paid by the entity. However, other states have published guidance stating that no credit will be allowed; rather, there is a reduction to the owners’ state taxable income by the income included and taxed due to the PTE. There also may be apportionment and tax base planning available to taxpayers making the PTE election depending on the taxpayer’s state tax footprint.
Finally, taxpayers must consider other consequences of the PTE before making any election. Example considerations include the existence of a higher state tax rate for the PTE and limitations on the ability to use state tax credits. In addition, it is always possible the SALT Cap will be repealed or the $10,000 state tax deduction limit will be increased. As a result, taxpayers should always keep an eye on federal income tax legislation to determine the likelihood of changes to the SALT Cap in future tax years.
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