Over 30 states have enacted regimes allowing pass-through entities (PTEs) that meet certain qualifications to elect to pay taxes at the entity level.
Deciding whether to make a pass-through entity tax (PTET) election, involves many factors and can involve unintended consequences. To help determine if a PTET election is right for you, review several frequently asked questions below.
Background on Pass-Through Entity Tax Elections
2017’s Tax Cuts and Jobs Act (TCJA) limited the itemized deduction for state and local taxes to $10,000 for both single and married filing jointly taxpayers. In November 2020, the IRS issued Notice 2020-75, providing guidance for certain state tax payments made by PTEs.
The notice states that state and local taxes imposed upon and paid by a PTE are allowable deductions under Internal Revenue Code (IRC) Section 164, reducing a PTE owner’s distributive or pro-rata share of income from the PTE.
The general thrust of a PTET election involves a PTE paying a state tax that would otherwise be borne by the PTE owners. However, the specific rules for making a PTET election vary significantly by state. Several frequently asked questions and key issues that can be traps for the unwary are addressed below.
Does the Ownership Structure of the Pass-Through Entity Preclude Making the Election?
Review whether the state you’re analyzing will allow the entity to make a PTET election. Some states, such as Idaho, allow PTEs with many types of owners, including corporations, to make a PTET election.
Other states, such as Oregon, impose significant restrictions based on the PTE’s ownership structure like requiring ownership either by individuals or PTEs owned only by individuals.
To complicate matters further, the state’s definition of individual may or may not include single member limited liability companies (SMLLCs) owned by individuals, grantor trusts, or qualified subchapter S trusts (QSSTs).
What Steps Must Be Taken to Make the Pass-Through Entity Tax Election?
It’s important to understand the PTET mechanics in the state where you're considering making the election. Some states allow the election to be made on the PTE return when originally filed and don’t require any specific election form or estimated payments. Other states mandate that the PTE make certain advance payments.
For example, a PTE was barred from making a 2022 California PTET election unless if by June 15, 2022, it paid the greater of either 50% of its 2021 PTET liability or $1,000.
It’s also important to review who may make the election. For example, many states note that the election must be made by an officer, manager, member, or owner of the entity who’s authorized to make the election. If a PTET election appears beneficial, PTE documents should be reviewed to determine who has this authorization.
If no party appears to have this authority, legal counsel should be contacted to see if further actions must be taken.
Will the Pass-Through Entity Tax Election Provide Tax Benefits?
Your analysis of a state’s PTET election should include an analysis of the potential US federal and state tax benefits. This analysis should incorporate several considerations, including:
- Which entities are included in the calculation? If a partnership has a C corporation (C corp) owner, is the C corp income in the tax calculation?
- Are amounts flowing through to certain owners, such as upper-tier PTE owners, included in or excluded from the tax base?
- Does the tax base include only income apportioned to that state, or does it include the entire distributive share of income assigned to in-state resident owners?
- May eligible owners opt out?
- Does the state limit the credit allowed? For instance, Massachusetts limits the credit to 90% of the taxpayers’ Massachusetts tax. California limits the credit to $5 million in the 2021 and 2022 tax years.
- Can the tax base be modified for income assigned to tax-exempt entities such as employee stock ownership plans (ESOPs?
- If the PTET credit exceeds the owner’s tax, is the credit refundable or nonrefundable? If nonrefundable, may the excess credit be carried forward and for how long?
- Is another state tax credit (OSTC) allowed on the owner’s resident or nonresident income tax return?
One crucial, and complex issue is the OSTC. To mitigate double taxation, most states allow their residents to apply a credit for the taxes the residents pay to other states on income that’s taxable by both states, such as distributive shares of PTE income sourced to the nonresident state.
In determining whether a PTET election will benefit the PTE owners the availability, calculation, and application of the OSTC should be reviewed. Considerations include:
- Does the state allow an OSTC for taxes paid by entities as well as by individuals?
- If the state limits credits for PTET to taxes paid to states with substantially similar PTE regimes, has the state issued guidance on which states qualify?
- How will the credits apply for taxpayers who make PTET elections in more than one state?
Critical exceptions to this general rule are the provisions of states known as reverse credit states.
Reverse credit states allow the nonresident to apply a credit against the tax calculated on the nonresident return for taxes paid to the resident state. In evaluating whether a PTET election will benefit the owners, you’ll want to identify any reverse credit states and consider how these states will calculate the OSTC allowed for:
- Nonresidents who elect in their nonresident state
- Nonresidents who elect in their resident states
- Residents who elect in their nonresident state
- Residents who elect in their resident state
These calculations can be extremely complex, particularly when reverse credit states are involved, or when owners make elections in more than one state. The net tax to any individual is highly dependent on specific facts, and early consultations with tax advisors is recommended.
How Does a Pass-Through Entity Make an Election?
When an entity has determined an election is available and beneficial, it’s time to review the state’s requirements for making a timely and valid election. State requirements for elections span a wide gamut, from submitting special forms with required documentation to simply checking a box on a timely filed (including extensions) return.
Several questions should be addressed:
- Is there a registration requirement for the election?
- If the election is made on a timely filed return, does timely filing include extensions?What is required for a valid extension?
- Does the state require a separate election form?
- Must special identified payments be made to make the election?
- What forms must the entity provide owners to document their distributive shares of PTET credit?
We’re Here to Help
For guidance on state tax payments made by PTEs, contact your Moss Adams professional. You can also visit our Pass-Through Entity Services page or our State & Local Tax Services page for additional resources.