Refresher on the PTE tax: What you need to know
The pass-through entity (PTE) tax strategy is a work around to the limitation on the State and Local tax (SALT) deduction created by the Tax Cuts and Jobs Act (TCJA). Prior to the TCJA, individuals could deduct, subject to alternative minimum tax and overall itemized deduction limits, state and local taxes on their personal returns. However, beginning with the 2018 tax year, the TCJA limited the SALT deduction to $10,000.
Many taxpayers across the country, especially in high tax states, were outraged and looking for some form of relief. Since that time, the PTE strategy has been implemented by many states to provide that relief.
In general, a qualified PTE entity – an entity taxed as an S corporation, partnership, or an LLC taxed as either of the two – can make an election to pay a PTE tax on behalf of the owner’s/partner’s share of their qualified net income from the entity.
If the election is made and the PTE tax is paid, this will generate a tax deduction on the entity’s federal return, which in turn reduces the taxable income reported on the owners/partners federal K1. Hence, providing a deduction for the state taxes related to that income that otherwise would be limited to $10,000, if paid by the individual and deducted on their personal return.
Additionally, the PTE paid will generate a tax credit to partners that elect to participate in the PTE election and can be used to reduce their personal state income tax. It’s important to check if your state has any limitations on utilizing these PTE credits.
In general, electing owners can include estates, trusts, and certain single member LLC’s along with qualifying individuals. However, once again, each state may have a different definition of who are qualified owners that can participate in the PTE election.
Use of the PTE strategy is important to individuals and companies that are structured as a flow-through entity to maximize the SALT deduction and, in turn, reduce federal flow-through income, which might otherwise be limited or denied pursuant to the SALT cap rules.
Challenges related to the PTE:
- It is not quite clear in IRS notice 2020-75, if the deduction for the PTE payment at the entity level of an accrual basis occurs when the payment is made, or as accrued. The rules related to deduction for expense are complicated and cannot be discussed here, but we have been instructing our clients to make any PTE payments before the tax year end to secure deduction on that year’s federal tax return. Future guidance is expected on this issue as well as how subsequent years’ refunds of excess PTE payments are to be handled at the entity level.
- In general, the PTE payment is treated like any other tax expense on the federal return and is allocated pro-rata to owners based on ownership percentage. This means that some partners who opted out of PTE treatment would receive a tax deduction benefit even though they did not participate.
For S corporations this could mean that electing owners who participated to get the higher deduction would not share in their full benefit; and non-electing owners would have a corresponding reduction to their share of income. Any cash distribution to correct this inequity could result in a second class of stock issue. Practitioners have requested the IRS address this issue and allow for a resolution.
Partnerships could amend their operating agreement to allow for a special allocation of the PTE deduction to adjust for this issue.
- In many states, the PTE election is irrevocable and made annually on an original, timely filed return including extension. Some states, i.e., California, require action to be taken during the current year or prior to year-end for the election to be valid for the tax year.
What should you do?
If you are a partner in any flow-through entity, you should inquire with the managing member or entity contact if the entity is eligible for the PTE and if a timely election has been made.
If your flow-through entity has made the PTE election, you should confirm that any required or estimated PTE payments have been made prior to year-end, to help ensure deductibility on the current federal tax return.