Federal treatment of PTET workarounds

Overview

Since the passage of the Tax Cuts and Jobs Act (TCJA), taxpayers have dealt with a $10,000 limitation ($5,000 for married taxpayers filing separately) for state and local tax (SALT) payments if they itemize their deductions on their individual income tax return. Even though this deduction limitation currently sunsets after 2025, 37 jurisdictions have enacted workarounds designed to help taxpayers deduct more of their SALT payments. These pass-through entity tax (PTET) regimes allow partnerships and S corporation entities to make an election to essentially pay the state tax liability on behalf of the respective owners. This gives rise to a deduction for state taxes on the federal pass-through entity return (instead of the limited deduction on the individual owner(s) return).

Types of PTET regimes

Most states allow pass-through entities to elect into their PTET regime. Within these elective states, some permit each owner to decide to opt-in, while others require all owners to participate once the election is made. Some states have an elective PTET in the first year, but once such an election is made for the initial year, it is binding for subsequent years.

States with a PTET workaround generally fall within two categories:

• A deduction/exclusion for previously taxed income on the owner’s individual return (thereby reducing state taxable income), or
• A credit related to the tax liability incurred by the pass-through entity (giving rise to a dollar-for-dollar reduction of the state’s tax liability).

Both methods reduce an owner’s overall federal liability. However, states providing a credit mechanism may disproportionately impact different owners. Unless all owners share the same tax attributes (including residency), it is likely some owners will not be able to utilize certain state PTET benefits. This leads to two issues. The first is the allocation method of the state tax credit and the second is whether there should be “true-up” distributions if this credit is specially allocated (in a nonpro-rata manner) to impacted owners.

Depending on whether the pass-through entity is a partnership or an S corporation, these issues may have differing resolutions. In all cases, pass-through entities should carefully analyze and model how the different programs can impact their owners. For example, a state’s PTET tax rate may be higher than its individual tax rate, which could ultimately lead to a higher state tax bill for the owners. PTET payments also impact any potential section 199A deduction. Consequently, determining whether to opt-in or out of a PTET regime can be a complex process, especially when there are numerous state filings and owners residing in different states.