With the passage of the 2017 Tax Cuts and Jobs Act (TCJA), many higher earners were hit with a rude surprise. The TCJA placed a $10,000 cap on allowable state tax deductions (SALT Cap) for federal income taxes. The cap disproportionately affected states known for high real estate prices, but all states felt the additional burden. Since then, states have been working feverishly for workarounds that could bring income tax relief to individuals impacted by the cap.
The IRS has systematically disallowed most of the proposed workarounds but did sanction one that allows the owners of pass-through entities to exceed the SALT cap by claiming the deductions through their businesses. With the release of Notice 2020-75, business owners may now use the pass-through entity (PTE) election to circumvent the SALT limitations on deductions.
What is the Pass-Through Entity Tax?
The PTE workaround is viable because the SALT cap only pertains to individual taxpayers. Owners of pass-through entities, such as partnerships and S corporations, can elect to pay their state income taxes at the entity level rather than on their individual tax returns. Because pass-through entities have no limit on the amount of state taxes they can deduct for federal tax purposes, state taxes paid become a federal tax deduction for the entities, effectively alleviating the SALT cap burden from their individual income taxes.
As of December 1, 2021, nearly 20 states have enacted the PTE election, including Alabama, Arizona, Arkansas, Colorado, Connecticut, Georgia, Idaho, Illinois, Louisiana, Massachusetts, Maryland, Minnesota, New Jersey, New York, Oklahoma, Oregon, Rhode Island, South Carolina, and Wisconsin. Four other states have legislation pending, including North Carolina, Ohio, and Pennsylvania.
The PTE effective date is the 2021 tax year for all states except Arkansas, Arizona, Colorado, Georgia, and Illinois, which set the 2022 tax year as their effective date.
Look Before You Leap into PTE
However, there are some real and potential caveats PTE taxpayers need to consider. The first is whether the state allows the PTE election to be made on an annual basis or it becomes a permanent election requiring a state’s approval to change.
Secondly, state provisions vary as to how the PTE will impact an owner’s individual income taxes. Some states allow owners to claim an income tax credit for their portion of the PTE tax paid by the entity. Other states don’t allow owners to claim a credit but, instead, allow them to reduce their state taxable income by the amount of income taxed due to PTE.
There are also questions with some states as to whether they might institute a higher tax rate on pass-through entities or limit their ability to use state tax credits. Suffice to say, pass-through entity owners must consider several outstanding issues before electing PTE status that is best addressed with a tax advisor. Schedule a free tax consultation with Glass Jacobson if you need help with the PTE workaround.
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