As we approach the final weeks of the year, there is a new and important tax planning opportunity to consider for your Partnership and/or S-corporation business, the timing, and deductibility of pass-through entity state income tax payments. This eblast is time-sensitive because you will need to act by December 31, 2021 in order to receive a tax deduction for 2021.
What is the Pass-Through Entity Tax (PTET)?
Generally speaking, the PTET is an entity-level state income tax that Partnerships and S-corporations may elect to pay and deduct as an ordinary expense at the business level instead of as an itemized deduction at the individual owner level. The PTET would offer those owners the benefit of a business-level federal deduction for the full amount of state income taxes paid. The alternative to PTET would be to lose the state income tax deduction on the personal level because of the State and Local Tax (SALT) deduction cap of $10,000.
So what’s the big deal, and why is this a new or novel tax planning strategy beginning in 2021? Back in 2017, the Tax Cuts and Jobs Act (TCJA) signed into law a $10,000 cap on the amount of SALT payments that an individual can deduct on their personal tax return for tax years 2018 through 2025. In response to the TCJA, many high-income tax rate states, such as Illinois, California, and New York, passed legislation that would allow its residents to work around the $10,000 federal SALT cap and reduce their federal taxes. The IRS announced in Notice 2020-75 that it intends to issue future regulations approving this new PTET workaround and allow a federal deduction for state and local income taxes paid by a Partnership or S-corporation in the year it was paid.
The PTET workaround allows business entity owners in their states to treat state income taxes as an ordinary business deduction, bypassing the $10,000 SALT limitation. At the state level, the individual generally receives a state income tax credit for such taxes paid by the entity under the PTET election, and this credit offsets the individual state income tax on the Pass-Through Entity (PTE) income.
Various states have since enacted elective PTET regimes, including their own filing forms and deadlines. For businesses engaged in multiple states, the PTET election might be available in at least some of those other states.
Other Issues to Consider
One big question at this time is whether an accrual basis taxpayer can claim a current-year deduction for a PTE paid in a following year. Unfortunately, IRS Notice 2020-75 stated that a deduction is allowed for the taxable year in which the payment is made. There is no additional guidance at the moment on whether it is permissible to deduct PTE taxes in the year accrued.
Single Member LLCs that are treated as disregarded entities for federal tax purposes are not eligible to participate in PTET elections to claim a SALT deduction.
There are special rules for a tiered partnership structure. A partner in an upper-tier is allowed a deduction for its share of PTE expense flowing from a lower-tier entity that made a PTE election.
Although an Illinois Investment Partnership is qualified to make a PTE election, we might want to consider the impact of Illinois Replacement Tax and deductibility of PTE tax paid by an investment partnership if the majority of its income is considered portfolio income (i.e., interest, dividends, and capital gains).
If you have questions about the potential tax implications of the Pass-Through Entity Tax (PTET), please contact your MichaelSilver tax professionals at 847.982.0333. We are here to help.