For companies that operate as pass-through entities, recent changes to state tax laws in many states have unlocked a fantastic opportunity to deduct state taxes in excess of the $10,000 State and Local Tax cap, otherwise known as the SALT cap.
The passage of the 2018 Tax Cuts and Jobs Act placed a $10,000 limit on the state and local tax deductions that individual taxpayers could claim on their federal income taxes. Previously, there had been no limit. This change had a major effect on individuals with large taxable income, especially those living in or with activity in states with high levels of state taxes, as many of these taxpayers had previously been able to deduct these on their federal tax returns, reducing their taxes due to the IRS. In many instances, an individual’s tax liability increased by tens of thousands or even hundreds of thousands of dollars or more.
Fortunately, recent changes to tax laws in many states have created workarounds that make it possible for individual taxpayers that have pass-through business entities to legally circumvent the $10,000 limitation. These rules––now in effect in 30 states and counting––provide a powerful tax strategy but are extremely complex and demand sufficient documentation and the right legal structure.
Read on to learn more about these rules and how they might apply to your business. We will explore the intricacies of using these workarounds and share why it’s vital to have the support of a sophisticated accounting firm as you implement these strategies.
A pass-through entity, also known as a flow-through entity, is a legal entity where income passes through the business directly to the business’s partners or shareholders. Traditionally, pass-through entities are not generally subject to income tax, and the income generated by the business is taxed at the individual level––not the entity level.
Common forms of pass-through entities include sole proprietorships, limited liability companies, partnerships, and S-Corporations. The majority of business entities in the U.S. are considered pass-through entities.
The 2018 Tax Cuts and Jobs Act cap is in effect through 2025, but current indications are that the cap could be extended indefinitely.
This change continues to have a major effect on taxpayers who pay significant amounts of state and local taxes, including state income tax and property tax. In response, over 30 states have now passed new legislation that permits many taxpayers with flow-through business income to work around this $10,000 cap.
The workaround applies to taxpayers who have an ownership position in a pass-through business entity. While the regulations differ in each state, generally the laws allow pass-through entities to elect to pay state income taxes at the entity level, rather than the individual level. These taxes can then be fully deducted from the entity’s federal income tax return. This is possible since the SALT cap only applies to individual tax filers, not pass-through entities.
These taxes are referred to as Pass-Through Entity Taxes (PTET). In 2020, the IRS issued Notice 2020-75, affirming that they supported these workarounds, provided all state-level guidelines were followed.
This represents an opportunity for high-income taxpayers to reduce their Federal income taxes. Consider the example of an individual who owes $500,000 in state income taxes on pass-through business income. By electing to pay these state taxes at the entity level, rather than the personal level, this individual could save up to $185,000 in federal income taxes by being able to deduct the $500,000 in state income taxes on their federal return.
However, navigating these regulations is highly complex. The regulations governing PTETs vary significantly from state to state, and it might not always make sense for entities to make a PTET election, depending on the state and other economic circumstances.
This is a relatively new area of the tax landscape, and in many states, there’s little official guidance for individuals looking to take advantage of new regulations. Not every pass-through entity partner and shareholder is eligible to make this election. In some instances, entities may need to look at restructuring before certain partners or shareholders can realize these tax benefits. One important item to note is most states have enacted the PTET only through 2025 and then it is set to expire. It is thought that many states will extend the PTET if the $10,000 cap is extended past 2025.
The PTET is straightforward in some states and not so much in other states, and it can quickly become incredibly complex for businesses that do business in multiple states. Each state has its own set of rules and guidelines around the timing of when to make the election, eligibility, calculation, and more. Every state must be analyzed separately for their respective election procedures, eligibility, and overall benefit. Then there must be analysis of how the individual state rules interact with each other to determine the actual benefit.
For accrual basis taxpayers, there is much to consider in relation to which year the PTE tax can be accrued to receive the deduction. An accrual basis taxpayer needs to ensure they meet the all-events test in order to accrue the tax expense in the tax year, rather than postponing the tax deduction into the next tax year. On the other hand, cash basis taxpayers will want to make sure they pay any estimated taxes by December 31st of the tax year (for calendar year taxpayers) in order to claim the deduction in the tax year. Thus, year end planning is crucial for all taxpayers to ensure the maximum benefit in the tax year.
There are also considerations to be made at the individual level. In some states, if you elect PTET as a nonresident, you may not need to file at the individual level. Other states require you to file at the individual level and take a credit for the PTET paid. In some states, PTET rates differ from personal income tax rates, and in others, you might be able to purchase syndicated tax credits (i.e. Georgia film tax credits) to cover the tax at a discounted rate.
At Smith and Howard, we first identify if the taxpayer is eligible for PTET in the state(s) they are required to file in. The PTET analysis is then addressed on a holistic basis: from calculating the tax paid and deducted at the entity level, and ultimately calculating the Federal tax savings and resident and nonresident tax savings at the individual level. Finally, we review entity agreements to gain an understanding as to any tax distribution provisions that might come into play. This ensures that PTET results in an overall tax savings and does not trigger any unfavorable tax or non-tax consequences. Once a decision is made to elect PTET in a certain state, we then will determine timing of the tax payments or accrual in order to maximize the deduction in the current tax year.
All of these considerations, and others that we would need pages more to discuss, add up to this being a complicated tax strategy that’s nearly impossible to execute without the support of experienced tax professionals. That poses the question: how do you identify an accounting firm with the expertise to help you successfully make this election?
To successfully navigate the complex web of regulations that govern Pass-Through Entity Taxes, it’s important you have an accounting firm that’s well-versed in the best practices of this process. The right accounting partner proactively monitors unfolding tax regulations and determines how they affect your business.
That demands a firm with the scale to handle significant complexity and the capacity to take a proactive approach. Many states require that these elections be made by the filing date and do not permit entities to elect retroactively, and some even require the elections to be made in advance of the tax return filing. This proactive approach continues when determining whether your entity needs to make estimated tax payments or purchase state tax credits. Transactions like these have the potential to impact cash flow and must be budgeted for in advance.
It’s also optimal to work with a firm that can handle both your entity’s tax returns and your personal tax returns. This consolidated approach makes for a more streamlined, accurate process with minimal room for error.
At Smith and Howard, our tax practice stays current on the latest tax law developments and interprets how they apply to our clients. Our experienced tax professionals proactively explore whether the pass-through entity tax deduction and other advanced tax strategies like it, make sense for each of our clients on a regular basis.
To learn more about whether your business is eligible to elect to deduct state taxes above the $10,000 SALT cap, contact an advisor today.
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