How Can State Pass-Through Entity Taxes Help You?
Originally published on October 25, 2021
Updated on November 1st, 2023
If the Tax Cuts and Jobs Act (TCJA) limited your deductions for state and local income taxes, there’s good news. You might be able to leverage pass-through entity tax laws to help soften the blow.
When the TCJA was passed in 2017, it instituted a cap of $10,000 on the deduction related to state and local income taxes for individuals. Since then, states have sought workarounds to limit the impact of the federal cap. Several have recently passed taxes on pass-through entities (PTEs) to help individual taxpayers mitigate some of the lost deduction by reducing their overall state tax liability.
State and Local Tax Deduction Cap
Prior to 2017, individual taxpayers who itemized deductions on their personal tax return could take a deduction for the full amount of state and local taxes they paid. However, the TCJA’s $10,000 limit hurt taxpayers with large state and local tax burdens since they could no longer receive the full tax benefit of those liabilities.
How does a pass-through entity (PTE) play into this? In most states, PTEs don’t pay tax. They pass their items of income and deduction through to their owners (who ultimately pay the tax). Many of these owners are often individuals.
Some states have gotten creative to solve this problem by passing laws that impose a tax on flow-through entities. These statutes effectively shift tax from the individual owners to PTEs—for which deductions are uncapped.
How Does it Work?
We’ll use California as an example. That state’s law allows a pass-through entity to pay tax on its in-state income (as an S corporation would). The tax is typically based on the taxable income of the entity, which is an aggregate of the income and deductions of the individual owners. The tax is then a deduction for federal tax purposes to the PTE, which ultimately gets passed to the entity’s shareholders. Since this tax is paid by the business, it’s not subject to the $10,000 cap.
Once the PTE pays the tax, the individual owner receives a credit for their share of the tax paid by the entity. The individual can claim this credit on their individual state income tax return (the shareholder’s California return in our example). This allows the shareholder to reduce their California tax burden. Excess credits may be carried forward depending on the state.
In most states, this type of PTE tax would be optional but irrevocable once elected. One state, Connecticut, has made its pass-through entity tax mandatory.
Can This Really Work?
The IRS has signaled it would not challenge these types of taxes, agreeing that PTEs can take a federal tax deduction for state taxes paid. The net impact to states is minimal, because they receive tax revenue from the PTE tax with an offsetting reduction in personal income tax. However, depending on the state, there can be differences in the type of pass-through entities that qualify and limitations to the taxpayer credit.
Each PTE needs to evaluate what’s best for the entity and individual owners. In some states, elections for 2021 must be made by the end of the year. So it’s important to consult with a CPA team familiar with these state rules and your company’s situation.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
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