Maybe the least popular change brought about by the Tax Cuts and Jobs Act (TCJA) was a first-ever cap on the federal personal income tax deduction for state and local taxes (SALT).
- During 2018 through 2025, there is a $10,000 cap on deductions for the total of the following:state income taxes, or general sales taxes if elected instead of income taxes,
- state real property taxes, and
- personal property taxes.
Thus, for example, if you live in a high-tax state such as California or New York and owe $10,000 or more in property tax, that tax by itself will use up your $10,000 deduction. You’ll get no federal deduction at all for the substantial state income taxes you doubtlessly pay.
States have tried several workarounds to the SALT cap, with poor results.
But there is now one workaround available to pass-through business owners in a majority of states that really works: electing to have your pass-through business pay state income tax on its profits at the entity level.
What Is an Elective Pass-Through Entity Tax?
Pass-through entities (PTEs) include partnerships, limited partnerships, single-owner S corporations, multi-member S corporations, and multi-member LLCs taxed as partnerships or S corporations (most are taxed as partnerships).
Ordinarily, the partners or shareholders of a PTE pay federal and state income tax on the PTE’s taxable income.
The PTE itself pays no federal taxes because it passes the income to the partners or shareholders.
In states that have adopted a PTE tax, the partners and shareholders can elect to have the PTE pay the state income tax due on the PTE’s business income. This is equal to what partners and shareholders would otherwise pay on their personal tax returns. The PTE then claims a federal business expense deduction for the state income tax payments.
The $10,000 SALT cap does not apply to taxes imposed at the business-entity level, such as income taxes imposed on PTEs. Thus, there is no limit on the amount of state income tax a PTE can deduct.
The states that have enacted PTE tax elections handle them in two basic ways:
- Owner exclusion. In some states, the PTE partners’ and shareholders’ distributive share of PTE income subject to the entity-level tax is excluded from their income for state personal income tax purposes. (The corporation paid the tax, so the state has the tax money.) These states include Arkansas, Colorado, Georgia, Louisiana, Mississippi, New Mexico, North Carolina, Oklahoma, South Carolina, and Wisconsin.
- Owner tax credit. In most states, the PTE’s partners and shareholders include their distributive share of PTE income in their tax returns, add back the state income tax expense paid by the PTE, and then take a state tax credit for the state tax paid by the PTE. These states include Arizona, California, Idaho, Illinois, Kansas, Maryland, Massachusetts, Michigan, Minnesota, New Jersey, New York, Oregon, Rhode Island, Virginia, and Utah.
Example. ABC, LLC, is a two-member California LLC with $400,000 in net income. Both members pay over $10,000 per year in California property tax.
LLC pays no PTE tax
If the members don’t elect to have their LLC pay the California PTE tax, the LLC passes through $200,000 of income to each of them.
Each member pays a 9.3 percent California income tax on their PTE income for an $18,600 tax, or a $37,200 combined tax. This state tax is not deductible on the members’ federal income tax returns because they already reached the SALT $10,000 deduction cap from their property tax bills.
Thus, each member must pay federal income tax on the full $200,000 received from their LLC. If their tax rate is 24 percent, this is a $48,000 tax.
LLC pays the PTE tax
If both LLC members qualify and make the PTE election, the LLC pays a 9.3 percent PTE tax to the California Franchise Tax Board, which is $37,200 of its $400,000 net income.
This payment is a deductible federal business expense by the LLC, reducing its net income to $362,800.
Each LLC member reports $181,400 of net income ($362,800 x 50 percent) on their federal Schedule K-1. This results in a $43,536 federal income tax bill.
When the members file their individual California income tax returns, they each report $200,000 of net income from ABC, LLC ($181,400 federal income + $18,600 share of PTE tax paid to CA) and take a tax credit of $18,600 against their individual California income tax. As a result, they pay no individual California income tax on their LLC income. Meanwhile, they each save $4,464 in federal income tax.
Taking advantage of the PTE tax is better than fully deducting SALT taxes without limit as an itemized deduction because the PTE tax reduces the amount of income subject to federal self-employment tax. This is a 2.9 percent to 3.8 percent Medicare tax on all net self-employment earnings and a 12.4 percent Social Security tax up to an annual wage base ($147,000 for 2022).
Electing the PTE tax is advantageous even if you’re one of the 89 percent of all taxpayers who don’t have enough personal deductions to itemize. If you don’t itemize, any state income taxes you pay do not produce a federal deduction.
But when you make a PTE tax election, the state income taxes your PTE pays reduces your adjusted gross income. In effect, the PTE tax moves the state income tax deduction from an itemized “below the line” deduction to an “above the line” deduction allowed in the computation of adjusted gross income.
One drawback to the PTE tax is that it will reduce your qualified business income (QBI) for purposes of the Section 199A deduction. Every dollar in state tax your PTE pays will reduce your QBI by one dollar. In the example above, each LLC member paying $37,200 in state income tax may reduce their Section 199A deduction by as much as $7,440 (20 percent x $37,200 = $7,440).
At their 24 percent federal income tax rate, this could result in each member paying an additional $1,786 in federal income tax. Of course, how large a Section 199A deduction you may lose depends on your particular circumstances.
Key point. In this example, the members saved $4,464 with the PTE tax and lost $1,786 in tax benefit from the Section 199A QBI deduction. Overall, they won.
Many PTE owners don’t qualify for the full 20 percent of QBI deduction. Many PTEs engaged in service businesses don’t qualify for a Section 199A deduction at all. Thus, the members in the LLC deduction may have won by much more.
The IRS Gives Its Seal of Approval to Deductions for Pass-Through Entity Taxes
Does all this sound too good to be true? It is absolutely true.
The IRS issued a Notice in November 2020 announcing that PTE taxes are deductible by PTEs in computing their taxable income for the year in which the payment is made. Moreover, such payments need not be separately stated in determining PTE owners’ federal tax liability. Instead, they may be reflected in PTE owners’ distributive or prorata share of non-separately stated income or loss reported on Schedule K-1.
The IRS based its conclusion largely on a footnote in the TCJA Conference Report back in 2017 providing that
taxes imposed at the entity level, such as a business tax imposed on pass-through entities, that are reflected in a partner’s or S corporation shareholder’s distributive or pro-rata share of income or loss on a Schedule K-1 (or similar form), will continue to reduce such partner’s or shareholder’s distributive or pro-rata share of income as under present law.
The IRS stated in the notice that it intends to issue regulations on the treatment of state and local income taxes imposed on and paid by PTEs. It remains to be seen if this will happen before the $10,000 SALT cap expires in 2026. In the meantime, taxpayers can rely on the IRS notice.
Note that this IRS guidance applies only to specified income tax payments by PTEs. Business owners still are subject to the $10,000 SALT deduction limit for state property taxes or state income taxes on their wages.
Takeaways
In states that adopted a PTE tax, the partners and shareholders can elect to have the PTE pay the state income tax due on the PTE’s business income that would otherwise be paid by the PTE’s owners on their personal tax returns.
The PTE then claims a federal business expense deduction for the state income tax payments.
The PTE’s deduction for state income taxes is not subject to the $10,000 SALT tax limit because it does not apply to taxes imposed at the business-entity level.
States that allow PTE taxes either give electing PTE owners a tax credit or permit them to exclude their share of the PTE’s income from their income for state income tax purposes. (For this excluded income, remember that the PTE paid the tax to the state, so the state is not out any money.) The IRS has issued a notice approving state PTE taxes.
The PTE election is available only to entities taxed as partnerships or S corporations. Sole proprietors and single-member LLCs don’t qualify. Next week, we’ll publish Part 2 of this article, giving you more insights and covering more on how to make this work for you.
Please contact our office if you have questions about PTE election and other PTE-related matters.