Federal issues surrounding state pass-through entity tax regimes

Overview

The Tax Cuts and Jobs Act (TCJA) imposed a $10,000 limit ($5,000 for married taxpayers filing separately) on individual taxpayers’ itemized deductions for state and local tax (SALT) payments for the 2018 through 2025 tax years. In response, legislatures of states with high individual income tax rates began introducing pass-through entity tax (PTET) regimes in 2018, to circumvent the limit at the individual level. By allowing partnerships and S corporations to make an election that would subject them to an entity-level state income tax, a PTET regime shifts the deduction from the individual level, where it would be subject to the SALT cap, to the entity level, where it can likely be deducted in full.

Speculation ensued over whether the IRS would respect these arrangements for federal purposes or invalidate them on the grounds they were abusive, in place solely to avoid the statutory SALT cap. Finally, in November 2020, the IRS released Notice 2020-75 (Notice) announcing its intent to issue proposed regulations addressing the treatment of such payments. In advance of the proposed regulations, the Notice permits pass-through entities to deduct “specified income tax payments” in computing their federal non-separately stated income or loss). While welcome news to taxpayers and practitioners, the Notice left many questions unanswered, and to date the proposed regulations have not been released, nor has any further guidance.

PTET mechanics, prevalence

The defining characteristic of a pass-through entity (PTE), for tax purposes, is how it “passes” its income through to its owners to be taxed on their respective returns, rather than at the entity level. This is generally true for both federal and state purposes. An owner would thus pay both federal and state tax on their distributive share of the PTE’s income. Prior to the TCJA, the PTE owner could claim a federal itemized deduction for the full amount of state taxes paid (unless the taxpayer’s income was high enough to subject them to limitations on the total amount of itemized deductions they could claim or was subject to the alternative minimum tax).

A state adopting a PTET regime provides PTE owners a workaround to the SALT cap as follows: Electing PTEs pay state income tax at the entity level, which the PTE may then deduct without limitation. The allowable PTET deduction reduces the PTE’s reportable federal taxable income; in turn, the PTE’s owners’ distributive share of federal taxable income will be lower due to the deduction of the PTET. This effectively creates the benefit of a state income tax deduction for PTE owners. Lastly, the state typically provides for the owner either to receive a credit against their state tax liability in the amount of their share of the PTET, or their state adjusted gross income to be reduced by their share of the PTET, preventing the income from being taxed by the state twice.