Defeat the $10,000 SALT Cap with the PTE Tax – Part 2

We explained in Part 1, a majority of states now allow pass-through entity (PTE) owners to get around the federal $10,000 state and local tax (SALT) deduction cap on individual taxpayers by having their PTE pay state income tax on its income at the entity level.

Under this regime, the PTE deducts the state income tax as a federal business deduction, which is not subject to the $10,000 SALT cap.

The PTE owners get either a state tax credit for the tax payment or a reduction in their PTE income for state income tax purposes. Either way, they end up with a full (or near full) deduction on their federal income tax returns for the state income tax on their PTE income.

This is a big win for PTE owners. Here’s some guidance on how to take advantage of this opportunity.

States That Have Enacted Pass-through Entity Taxes

To date, 29 states have enacted pass-through entity taxes. PTE taxes are elective in all states except Connecticut, where they are mandatory. These states are listed below with the year the PTE tax election first became available in parentheses:

  • Alabama (2021)
  • Arizona (2022)
  • Arkansas (2022)
  • California (2021)
  • Colorado (2022)
  • Connecticut (2019)
  • Georgia (2022)
  • Idaho (2021)
  • Illinois (2022)
  • Kansas (2022)
  • Louisiana (2019)
  • Maryland (2020)
  • Massachusetts (2021)
  • Michigan (2021)
  • Minnesota (2021)
  • Mississippi (2022)
  • Missouri (2022)
  • New Jersey (2020)
  • New Mexico (2022)
  • New York (2021)
  • North Carolina (2022)
  • Ohio (2022)
  • Oklahoma (2022)
  • Oregon (2022)
  • Rhode Island (2019)
  • South Carolina (2020)
  • Utah (2020)
  • Virginia (2021)
  • Wisconsin (2019)

In addition, PTE tax legislation is pending in Iowa, Pennsylvania, and Vermont.

Each state’s PTE tax regime is different. You need to carefully study the PTE tax rules for your state. Many states have issued detailed guidance as noted in the footnotes below. In particular, pay attention to the following issues.

Which PTEs Are Eligible for the Election?

The PTE tax election is available for entities taxed as partnerships or S corporations. This includes almost all multimember LLCs but excludes those single-member LLCs that are taxed as sole proprietorships.

In California, a single-member LLC that is a partner, shareholder, or member of a PTE may make a PTE tax election as to the income from that PTE.

Most states exclude publicly traded partnerships.

Many states also exclude PTE owners that are not individuals, trusts, or estates. Many states also don’t allow a PTE to make the election if it is owned by another PTE (i.e., part of a tiered partnership).

What Percentage of Ownership Is Required to Make the Election?

Do all the PTE owners have to agree to the election or just a majority? It varies from state to state.

In most states, the election applies to all the PTE owners.

But in Arizona and California, each PTE owner can choose whether or not to join the PTE election.

Before making the election, you should review your PTE’s partnership agreement, operating agreement, or bylaws to ensure that the proper voting procedures are followed. It’s possible that your agreement doesn’t permit such an election and may have to be amended.

Note that there could be complications if not all S corporation shareholders are eligible or if some choose not to make the PTE election. Providing PTE credits to some S corporation shareholders but not others could violate an S corporation’s one-class-of-stock requirement.

Most states require PTEs to provide their owners with notice that a PTE election has been made—usually by checking a box on the state’s K-1 provided to the owners.

What’s the Deadline for Making the Election?

Most states require that PTEs make the election by the original or extended due date of the entity’s state or PTE tax return. In these states, for the tax year ending December 31, 2022, the PTE election deadline is March 15, 2023.

New York and a few other states require that the PTE election be made by March 15 of the taxable year of election. In these states, the election for 2022 had to be made by March 15, 2022. But New York recently extended the 2022 due date for making a PTE election to September 15, 2022. Some states require electing PTEs to file an election form.

In other states, the election is made by checking a box on the entity’s regular tax return.

In most states, the election must be made annually and is irrevocable. In some states, it is binding until revoked.

Most state PTE tax election laws provide that the tax ends after 2025 when the $10,000 federal SALT cap is set to expire.

Are Estimated PTE Taxes Due?

Meeting the due date for the PTE election is only half the battle. Most states require PTEs that wish to make the PTE tax election to pay estimated income taxes to the state during the tax year of the election. Thus, such taxes are ordinarily due before the PTE tax election must be made.

In most states, you must pay PTE estimated taxes on the same dates as regular estimated taxes. These taxes are usually paid quarterly, with the first quarter payment due on either March 15 or April 15, depending on the state.

Generally, missing an estimated tax payment deadline only results in an underpayment penalty.

But starting in 2022, California uniquely requires a single estimated PTE tax payment equal to the greater of $1,000 or 50 percent of the PTE’s California PTE tax liability for the prior year. This payment is due by June 15 of the tax year of the election.

Thus, the payment for 2022 was due June 15, 2022. If you missed this deadline for your California payment, you have no PTE election for 2022. You’ll have to wait until 2023 to make a California PTE election.

How Much Is the PTE Tax?

PTE tax rates vary from state to state, just like state income tax rates. Some states have adopted a graduated rate structure. Others use the highest individual tax rate. Others have a flat rate. For example, California’s PTE tax rate is 9.3 percent, which is less than its top state income tax rate of 13.3 percent.

PTE Credit Versus Exclusion

In most states, the PTE’s owners claim a credit for the amount of their distributive share of the taxes paid by the PTE.

In Connecticut and Massachusetts, the PTE credit is only partial.

In most states, the credit is not refundable, but it can be carried forward to future years.

In some states, there is no PTE credit. Instead, the PTE owners’ distributive share of PTE income subject to the entity-level tax is excluded from their income for state personal income tax purposes.

Non-Resident PTE Owners

The PTE tax gets more complicated if a PTE has any non-resident owners. Most states allow non-resident owners to claim PTE tax credit only on their apportioned share of income “sourced” to the state.

In some states, non-resident PTE owners are not required to file state returns if they have no other state-source income. In others, they are still required to file returns if they meet the state’s gross income tax filing thresholds. States also differ on whether non-resident partner or shareholder withholding is required when the PTE election is made.

Many states allow PTE owners who are non-residents of the PTE’s election state to claim a tax credit on their resident state income tax return for their share of the taxes paid by the PTE. Typically, this is allowed only if the PTE taxes paid in the election state are “substantially similar” to the state’s PTE tax.

Some states do not permit credits for taxes paid to other states at the entity level. If a state does not allow a state tax credit for elective PTE taxes, a PTE tax election could result in an additional state tax burden for non-residents that exceeds their federal itemized deduction benefit.

Takeaways

Here are five takeaways from this article:

  1. 29 states have now enacted state pass-through entity taxes that enable PTE owners to get around the $10,000 SALT deduction limit by having their entity pay state income taxes on its profits.
  2. The PTE election is available only to multi-owner pass-through entities taxed as partnerships or S corporations. Sole proprietors and single-member LLCs are excluded.
  3. In most states, not only must PTE owners make a PTE tax election, but the PTE must also pay estimated state income taxes. The estimated taxes usually must be paid before the deadline for making the election.
  4. In most states, the PTE’s owners claim a credit for the amount of their distributive share of the taxes paid by the PTE. In other states, the owners’ distributive share of income subject to the entity-level tax is excluded from income for state personal income tax purposes.
  5. Most states, but not all, permit non-resident PTE owners to claim a tax credit on their resident state income tax return for their share of the taxes paid by the PTE.