The state and local tax deduction limit of $10,000 for individual taxpayers (“SALT cap”) can create significant disparity between operating a business as a pass-through entity or as a C corporation. C corporations can deduct all state income taxes from federal taxable income. Owners of pass-through entities pay tax on the income flowing from the business and cannot deduct more than $10,000 of state income tax. The SALT cap continues to be a contentious issue in Congress.
Twenty-one states have now enacted legislation to “work around” the SALT cap and allow qualified pass-through entities (“PTE”) to make an election to impose state income tax at the entity level rather than on the individual owners. This allows partnerships and S corporations to pay state income tax in the same manner as a C corporation. To learn more, read Cherry Bekaert’s article, The Growing Trend of Pass-Through Entity SALT Cap Workarounds.
In Notice 2020-75, the IRS indicated that forthcoming regulations will be drafted to allow pass-through entities making valid elections under state law, and making payments of state income tax, to deduct the state income tax from the entity’s federal taxable income. Thus, it appears the IRS may permit these state PTE election initiatives to help owners of pass-through businesses to avoid the SALT cap.
Now that partnerships and S corporations have the opportunity to deduct state taxes as C corporations do, they must also pay state taxes as C corporations do, which includes quarterly estimated tax payments and payments with extensions of time to file returns. For a partnership or S corporation electing in to one of the PTE state tax regimes, state taxes may be due in full for all of 2021 at the time the extension is filed. If the pass-through entity owners have already made quarterly estimated tax payments themselves in 2021, there could be a double tax cost until the owners receive a refund of their overpaid tax. In addition, the partnership or S corporation must also be ready to make a first quarter estimated tax payment for 2022.
States that have enacted PTE elections effective for the 2021 tax year include: Alabama, California, Idaho, Illinois, Massachusetts, Michigan, Minnesota, New York, and South Carolina. States enacting legislation in earlier years include Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island and Wisconsin. And finally, states with elections that go into effect in 2022 include Arizona, Arkansas, Colorado, Georgia, North Carolina, and Oregon.
Unfortunately, the legislation is not uniform among states. Instead, each state is adopting legislation that addresses its unique nuances and preferences. Therefore, if a pass-through entity has any significant income in a state that offers an election, the rules should be reviewed to determine qualification requirements, method of election, and overall impact of making the election. Perhaps of greatest importance is the state tax treatment in the resident state of the owner. If the resident state does not offer a credit for tax paid to other states at the entity level, overall tax may actually increase as a result of the election. Not a result anyone wants!
As in most things tax related, determining whether there is an actual opportunity to reduce overall tax will depend on the pass-through entity and its owners’ specific facts and circumstances.
If you have questions on this topic or other tax matters, please reach out to your Cherry Bekaert advisor.
