State PTE (Pass-Through Entity) Election: the SALT Cap Workaround

The Workaround for the State and Local Tax (SALT) Cap

Many states have been following the trend of passing PTE (pass-through entity) election laws in the wake of the enacted SALT cap for individual itemized deductions. The benefit of a PTE election is that the entity pays the state income taxes due, rather than the individual partners or shareholders who would then take the SALT deduction on their personal returns. This is essentially a “workaround” of the $10,000 SALT cap because this cap does not apply to entities.

There are a few considerations that need to be taken into account before making the PTE election in any state…

First, the taxpayer should consider if the election will need to be made on an annual basis or if it is irrevocable once made. If the election in that state is irrevocable, it may be difficult to change later and the state may require a written explanation as to why the taxpayer wants to revoke the election.

Second, the taxpayer should consider the effects of the PTE election on their own personal income tax return. Some states have said that the owners of a PTE making the election can take an income tax credit for their share of the PTE tax paid by the entity. However, other states have noted that they won’t allow a credit. Instead, those states provide for a reduction to the owner’s state taxable income by the income included and taxed due to the PTE.

Thirdly, the consequences of a PTE election should be considered for each individual taxpayer and entity. It’s possible the tax rate for the PTE is higher and there may be limitations on the ability to use credits.

It’s also possible the SALT cap gets repealed. At the date of this publication, this is an unknown as the legislation is being debated within Congress. House members in higher tax states especially have proposed raising the SALT cap to $80,000. Back in 2020, the IRS promised to issue regulations that would provide more guidance on the state PTE taxes as a workaround, but so far there has been no word. It is likely not high on their priority list as the SALT cap expires on December 31, 2025. 

Reporting: How Will You Need to File the PTE Election?

In terms of filing the PTE election, some states require that everything be submitted electronically.

Examples include:

• Massachusetts, which has Form 63D-ELT which is filed electronically and is used to confirm the PTE election.
• In Oklahoma, a PTE must first file a special form to make the PTE election, then wait for an acknowledgement letter. This letter then must be attached to the PTEs annual tax return where the filer must check a special box. Then the PTE must provide a copy of the letter to each of its members and they must attach the letter to their personal tax returns.
• On the other end of the spectrum, Michigan says a payment by the PTE of the PTE tax online is all that is needed to make a valid PTE election.

Because of these differing rules, it is important to review each state’s filing requirements when it comes to making this election as most states will have unique ideas on how to file the election. 

Updates in Legislation

One of the most recent states to update their PTE election legislation is California on February 9, 2022 with Assembly Bill 87. Previously, under A.B. 150, only qualifying entities were eligible to make the PTE tax election, which did not include pass-through entities with owners that are partnerships. Now, under A.B. 87, pass-through entities that have partnerships as partners are considered qualified entities that can make the PTE election.

REDUCING NET INCOME

Additionally, the PTE tax credit can now reduce net income tax below the California Tentative Minimum tax. Previously under A.B. 150, the PTE tax credit was limited to offset only regular tax in excess of California Tentative Minimum tax. These changes are effective for tax years beginning on or after January 1, 2021.

Some other updates that are effective for tax years beginning on or after January 1, 2022 include a change to how the taxes paid to other states are claimed. Previously, the credit for taxes paid to other states was claimed by a qualified taxpayer after their PTE tax credit. With this, some taxpayers could lose a portion of their credit. Now, under A.B. 87, the credit for taxes paid to other states can be claimed before the PTE tax credit. 

Overall, due to the changes in California, taxpayers should consider whether they may qualify for the PTE election where they might not have qualified previously.  

In New York, the PTE election is annual, optional, and irrevocable to pay tax on certain income for tax years beginning on or after 1/1/2021. Before an entity makes the election in New York, they should consider how the calculation of taxable income differs between S corporations and partnerships. Individuals should also consider if the entity is filing composite or not because the PTE election is not available for nonresident owners included in composite returns. If the election is made, it must be done by an authorized person which is then binding for all partners or shareholders of the pass-through entity. 

*Additionally Ohio, Pennsylvania, and Virginia currently have proposed PTE tax bills.  

WE WELCOME YOUR QUESTIONS

The PTE tax election rules can be very complex and vary from state to state. The REDW SALT team has the expertise to assist and guide you through these very complex rules and regulations. Please feel free to reach out to Jeanna Schenk or George Rendziperis below.