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.

Partnerships

Partnerships have inherent flexibility with respect to how items of income, expense, deduction and credits are and can be allocated. Even so, entities taxed as partnerships must still follow certain rules when allocating state PTET credits to partners. The Internal Revenue Code requires partner allocations to have substantial economic effect. Basically, this means that allocations must be consistent with the underlying economic arrangement between the partners. Income and gain allocations must be proportionate to actual distributions of money and property while expenses and losses have to conform to each partner’s share of actual liabilities for partnership expenses. Otherwise, these allocations, such as credits, must be made in accordance with the partner’s interest in the partnership.

With respect to PTET regimes, the federal deduction for the PTET payment can be specially allocated to specific partners if such allocation follows the economic benefit to such partner(s). The corresponding state PTET credit would then have to be allocated in accordance with the expense to meet the substantial economic effect test. Operating agreements may need to be amended in order for this treatment to take place.

S corporations

Unlike partnerships, S corporations are obligated to allocate items of income, gain, deduction, loss and credit pro rata among shareholders. The federal deduction for the state(s) PTET payment(s) will be allocated pro rata between all shareholders regardless of whether certain shareholders receive a greater benefit from the actual PTET payment.

Whether the pro rata requirement applies to the allocation of state credits, or if a special allocation of a state credit violates the one class of stock rule, remains unsettled. Furthermore, many shareholders argue the allocation of state tax credits should be trued-up so that those not receiving the benefit of the PTET credit can still be made economically whole. In these situations, there is a possibility a second class of stock has been created; thereby having a detrimental effect on the S election.

Tips and tools

The issues for both partnerships and S corporations get more complicated for entities with multistate operations, owners with differing states of residence, and/or partners/shareholders with varying desire to participate. These regimes are less complicated for entities with operations in a single state and all owners are residents of that state.

In addition, numerous issues should be considered when modeling whether to opt into one or more PTET regimes. Some of the questions to ask when analyzing any benefit from making a PTET election are as follows.

Making the election

• What is the due date for the election? Has the date passed for the year in consideration?
• Is the election binding for future tax years?  Will anticipated changes in ownership, residency, taxable income or other circumstances make the election less beneficial in future years?
• Is the election revokable?

Tax calculation

• Is there a different rate for the PTET than the owners would otherwise pay?
• Is there a difference in taxation of items like capital gains for PTET that would make the election less beneficial?
• If the state taxes resident income at 100% apportionment, is there a credit allowed for composite, withholding and/or other PTE taxes paid?

Owner-level considerations

• Is the owner still required to file an income tax return in the state when PTE is elected?
• Is the income subject to PTE tax still reported at the owner level? If so, how much of the PTE tax paid is allowed as a credit on the owner’s return? Is the credit refundable?
• Are there credits calculated at the entity level passed through to shareholders that may not be credited against the entity level tax? (Example - Wisconsin Manufacturing Credit)

Estimated payments

• Are estimated payments required?  How are they calculated and when are they due?
• If estimated payments were made for composite or withholding taxes, will they automatically apply against PTE tax, or would effort need to be made to transfer payments?
• If estimated payments have not been made or were not sufficient, will underpayment interest and penalties reduce the expected benefit of making the election?

The future of the SALT deduction

Although the $10,000 cap on the SALT deduction expires after 2025, there have been several proposals on Capitol Hill to expand the cap or repeal it altogether. A bipartisan congressional SALT caucus has formed in an effort to influence tax legislation, wanting to ensure any tax-related bills contain at least some increase in the cap. In addition, multiple SALT-specific bills have been introduced, just in 2023, ranging from raising to a higher amount the $10,000 cap through full repeal. However, expect little, if any, movement on these bills in a closely divided Congress, unless they can be attached to an appropriations bill.

It is also possible that if various individual relief provisions expiring under the TCJA are extended, the SALT cap will get extended beyond 2025 to offset the cost of the expiring provisions.

Meanwhile, requests have been made to Treasury to allow PTET state tax credits to be treated in the same manner as composite payments (as constructive or deemed distributions). However, the IRS currently seems unwilling to provide taxpayers with further guidance as to how these PTET regimes are to be handled. As a result, work with your tax advisor to model the best use of the PTET for your situation.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.