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Navigating the Pass-Through-Entity Tax as a Workaround to the State and Local Tax Deduction Limit by Maxwell Jewell, CPA, MST

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Posted on December 16, 2024 by Maxwell Jewell

Since the enactment of the Tax Cuts and Jobs Act (TCJA) in 2017, several states have proposed optional pass-through entity taxes (PTETs) to help their residents escape the law’s $10,000 limit on deductions for state and local taxes (SALT) payments on their personal income tax returns. However, because the PTET requirements can vary widely from one state to the next, business owners must tread carefully when assessing their unique tax positions in each jurisdiction where they operate and determining whether a PTET election makes sense in each location.

Background

The $10,000 SALT cap, which is scheduled to expire at the end of 2025, came at a considerable cost to taxpayers who could previously claim deductions on their federal tax returns for payments of state income, sales, property and real estate taxes.

Those most impacted by the law include high-income taxpayers who live in states with property taxes that exceed the $10,000 threshold and who previously relied on those SALT deductions to reduce their federal income tax liabilities. In response, lawmakers in several states proposed various measures to help their residents circumvent the cap and maximize their deductions. The one that received IRS approval is an elective pass-through entity tax (PTET) currently in effect in 36 states and New York City.

The profits of pass-through entities (PTEs), such as S corporations, partnerships and limited liability companies (LLCs), typically flow to their owners, who pay taxes on those amounts at their individual tax rates. However, under a PTET regime, those businesses may elect to pay state income taxes at the entity level, removing them as personal owner expenses subject to the SALT cap. The company can then deduct those payments as business expenses on its federal tax return. This essentially reduces the business income that passes to the owners’ personal tax returns and provides them with a corresponding state tax credit against their individual income tax liabilities.

Conflicting Rules from State to State

 Businesses looking to take advantage of PTETs in states where they operate or where their owners reside must recognize the tax rates, election deadlines and rules for calculating their tax base and applying the credit can vary widely from one jurisdiction to the next. This can become a complex and time-consuming reporting compliance environment for entities operating across multiple states with often conflicting laws.

For example, taxpayers in states that include Arizona, California, Connecticut, Illinois and New Jersey can elect into their respective PTET regimes by March 15 after the close of a tax year. In stark contrast, PTEs in New York do not benefit from having their annual financial documents in hand before electing into the state’s PTET for a particular year. Instead, they must decide whether an election makes sense for them by March 15 of the tax year to which the election would apply. This requires considerable speculation about how owners expect their businesses to perform throughout the remainder of the year. Should they make an election in March and pay the required quarterly estimated PTETs through June, only to experience a significant downturn in September, they may find they overpaid PTETs to the state. Under these circumstances, they will still need to file PTET returns for that year and request a refund of all overpaid tax amounts, which could take time to process. New York state does not allow pass-through entity owners and shareholders to apply estimated PTET overpayments to the following year, nor does it permit entities to transfer estimated PTET payments between related parties or to any other tax liability. This is not the case in states, such as California, that allow entities to apply estimated PTET overpayments to the following tax years.

This lack of uniformity from state to state is not the only challenge businesses encounter when deciding whether to make a PTET election in each jurisdiction. Consideration must be given to how the entity is structured, the tax treatment of its owners and their percentage of business ownership, where owners are domiciled, whether they have individual income tax return filings in states where they are not residents and how much income is allocated to each jurisdiction based on the states’ unique apportionment rules.

When considering a potential liquidity event, it is important to consider how a PTET election may affect a future business sale or merger. For example, owners of pass-through entities generally prefer to sell stock rather than assets to yield beneficial long-term capital gains tax treatment on the sale proceeds. However, a stock sale for a business that elects into the PTET regime could result in state taxes imposed at the shareholder level and nullify the election’s intent to circumvent the SALT cap. By contrast, an asset sale will decrease the taxable income allocated to the shareholders and reduce their total tax costs. Buyers also prefer this type of transaction due to the step-up in tax basis they receive on the target company’s assets and their ability to recover the sales costs of those assets through depreciation and amortization.

A potential strategy PTEs can employ when selling to a private equity fund is to consider a F reorganization with a corresponding PTET election. This would involve creating a new company taxed as an S corporation to hold all of a business’s assets. After the PTE transfers all its assets to the holding company, the IRS considers it fully liquidated and disregarded for income tax purposes, and a sale or purchase of that operating company’s equity is then treated as an asset sale.

With the $10,000 SALT cap set to expire in December 2025, PTEs must consider the complexity a PTET election could add to their business tax compliance efforts. However, the potential savings for the entity and its shareholders or partners are worthy of deeper analysis.

About the Author: Maxwell Jewell, CPA, MST, is an associate director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where he provides tax and consulting services to high-net-worth families and businesses in the private equity and software sectors. He can be reached at the CPA firm’s New York City office at (646) 213-7600 or info@bpbcpa.com.