The Tax Cuts and Jobs Act of 2017 (TCJA) limited the state and local tax (SALT) deduction to $10,000 (also known as a SALT cap). Since then, many states have sought pass-through entity tax workarounds in response to the SALT cap. In November 2020, the IRS provided guidance allowing state tax deductions at the pass-through entity level; subsequently, many states have enacted pass-through entity taxes in response.
Pass-through entity taxes allow a pass-through entity to pay state tax at the entity level. The SALT cap of $10,000 applies to individual taxpayers. The pass-through entity taxes are taken as an S-Corporation or partnership deduction, therefore “flowing” to partners with no limitations, who then receive a credit against their state individual income tax liability or deduct their share of income from their adjusted gross income to determine their state tax liability.
Entities Most Likely to Elect Pass-Through Entity Tax
Entities are most likely to elect the pass-through entity tax if they have any of the following criteria:
- High taxable income
- Owners’ states of residence are all in one state and/or in non-taxing states
- Limited number of owners
- Entity is in highly apportioned states
- State includes all owners at 100 percent distributive share
- No net operating losses (NOLs) from prior years
- No tax credit carryforwards at owner level
Federal Tax Considerations
There are several federal tax considerations to evaluate when determining whether the pass-through entity election is made, including trade or business considerations, tiered partnership structures, and evaluations of any pass-through entity tax refunds. Others include:
- Timing of Deduction – For cash basis taxpayers, the year of deduction equals the year of payment. For accrual-basis taxpayers, there’s more to consider. Section 461(h)(3) has the following rules for accrual basis:
- All events are fixed and determinable;
- There was a reasonable period after the close of the taxable year or eight and a half years;
- The accrual is recurring in nature, and,
- The accrual results in a more proper match against income than accruing such an item in the taxable year in which economic performance occurs.
- Disproportionate Distributions – Be aware of certain actions that would impact distributions, e.g., resident vs nonresident, changes in economics, prorate allocation for S-Corporations or partnership special allocations.
Pass-Through Entity Tax Rate and Allocation
Pass-through entity taxable income varies among states, and in some cases, S-Corporations and partnerships are distinguished (e.g., New Jersey). States may have a single or fixed rate, a graduated rate or different rates for different owners. Allocation of the tax to entity owners is pro rata for S-Corporations and via an operating agreement for partnerships, which should be reviewed for consideration of special allocations or adjustments of distributions.
Tax Considerations for Owners
- Not all states allow resident owners a tax credit or modification for their share of pass-through entity net income tax paid to another state.
- A state’s ordering of tax credits should be evaluated to determine the impact to various credits, including state taxes paid to other states, pass-through entity tax credits, and other statutory credits passed through to the owner.
- A resident owner may receive a tax credit only if the pass-through entity has not made a resident state pass-through entity tax election in some states.
- Pass-through entity credit is refundable, or excess may be carried forward.
- Check credit rules for different states, as they may vary between S-Corporations and partnerships.
Georgia Pass-Through Entity Considerations
Pass-through entity tax in Georgia will be available starting for the 2022 taxable year at a rate of 5.75 percent. There are no deductions based on self-employment and no deductions for state income taxes. The pass-through entity must be 100 percent owned/directly controlled by persons eligible to be an S-Corporation owner. There is no nonresident filing requirement if the pass-through income is the nonresident’s only source of Georgia income. Georgia taxpayers should proceed carefully regarding tax credits as certain personal tax credits may find difficult in utilizing credits if they were generated before the election or generated in the pass-through tax entity elected years. Owners cannot transfer credits or estimated tax payments back to the pass-through entity.
Planning Ahead for Pass-Through Entity Tax
Taxpayers should expect more updates and changes to guidance around pass-through entity tax, and pay special attention to the rules as they can vary significantly from state to state. Remember, don’t make elections just because a state allows it – make the election where it makes the most sense. Taxpayers can consider the following to plan:
- Determine which states the company should elect pass-through entity tax, and consider the impact of elections in one or more states based on company operations and owners’ state of residence. It is critical to calculate the impact on each member based on the state of residence and tax position in each state.
- Document and evaluate the All Events Test and the potential for accrued expense deductions.
- Creating a multimember LLC from an SMLLC to allow the entity to make the pass-through entity election.
- Restructure the pass-through entity to include qualified members only.
- Amend partnership agreement to allow pass-through entity special allocations.
- No two states have the same pass-through entity rules – remember to look out for the following:
- Effective dates and election dates
- Impact of owner types for eligible entities
- Owner consent
- Tax base calculation
- Distributive share of the resident and nonresident owner included in the pass-through entity taxable base
- Credit vs. subtraction on owners’ returns
- Payment of estimated payment deadlines
- States’ acceptance of another state’s pass-through entity tax and allowing the resident a credit or subtraction for pass-through entity tax elections made in another state
- Tax credit ordering rules for the resident owner claiming credit for pass-through entity taxes, taxes paid to other states, and any other credits passed through
- Rules for nonresidents, including return requirements, composite returns, and nonresident withholding requirements
For more information, contact Tim Clancy at [email protected].
