Individuals are limited to deducting $10,000 ($5,000 for married filing separate) of state and local taxes (SALT) on their Federal income tax. Generally, income earned by pass-through entities (PTE) is taxed at the investor level, meaning business owners lose a valuable Federal income tax deduction for state taxes paid on income passing through from businesses they own. However, taxes imposed at the PTE level are not subject to the SALT cap limitation since these taxes reduce the investor’s distributive share of income reflected on Schedule K-1 and are not deducted directly by the investor.
By electing to participate in an Ohio composite return, Ohio residents avoid the SALT cap on taxes owed on income from PTEs they own. Additionally, these taxpayers may receive a benefit from the increased rate paid by PTEs on composite returns (highest individual income tax rate – 4.979% currently) compared to that owed by the individual on business income (3% currently). With the income tax filing deadline approaching, PTE investors and their professionals should be aware of the risks and benefits associated with filing an Ohio composite return.
IRS specifies that elective PTE-level taxes avoid SALT Cap.
Many states have, or are considering, income tax structures which allow PTE investors to elect to have the tax imposed at the entity level and claim a credit against their state income taxes for their pro-rata share of taxes paid by the PTE. In Notice 2020-75, the IRS states that these elective PTE-level taxes, referred to as Specified Income Tax Payments, are treated as entity-level taxes and avoid the SALT cap. Specified Income Tax Payments are taxes imposed directly on a partnership or S corporation, regardless of whether the imposition is the result of an election or investors receive a credit or other benefit for the taxes paid.
The partnership or S corporation deducts the amount of Specified Income Tax Payments made during the year, which reduces the amount of income that ultimately passes through to its investors. Therefore, such payments are not taken into account when applying the SALT cap at the individual level. The IRS Notice is applicable starting with the 2018 tax year.
Ohio residents can take advantage of SALT cap workaround by electing to participate in composite return.
Ohio imposes a mandatory PTE withholding tax on the distributive share of income allocated to nonresident investors. PTE withholding tax is reported and paid on Ohio Form IT 1140. The nonresident investor then receives a credit for tax paid by the PTE on his/her income (although the PTE withholding tax return does not satisfy the investors’ Ohio filing requirement). There was never any question that Ohio PTE withholding tax would avoid the SALT cap. However, since withholding tax only applies to income allocated to Ohio nonresidents, it was unclear whether Ohio residents owning PTEs could also take advantage of the SALT cap workaround.
Based upon IRS Notice 2020-75, even Ohio residents can avoid the SALT cap on income earned through PTEs by electing to participate in a composite return, Ohio Form IT 4708. PTEs filing an Ohio composite return and paying tax on behalf of its investors operates precisely as Specified Income Tax Payments are described in the IRS Notice – PTE owners make an election to impose tax at the entity level and receive a credit for tax paid on their behalf. By electing to file a composite return, the PTE is liable for any additional taxes, interest, and penalties that may be imposed on the investors’ income. R.C. 5747.08(D)(4).
Moreover, PTE investors may actually receive an additional benefit by electing to file a composite return. When making such an election, the PTE pays Ohio income tax at the highest individual rate (currently 4.797%) without accounting for certain deductions, mainly the $250,000 business income deduction. However, when the investor files his/her individual Ohio return, the investor would only owe tax at 3% with a $250,000 ($125,000 if single or married filing separate) deduction to the extent the PTE income is considered business income. R.C. 5747.01(B). Therefore, the investor would benefit from claiming the Federal deduction based upon the higher taxes owed by the PTE, while potentially claiming a credit for taxes paid by the PTE against income from other sources or a refund for Ohio individual income tax purposes.
Ohio’s composite return election provides Ohio individual income taxpayers owning PTEs with the ability to workaround the Federal SALT cap, although with some risk as the PTE assumes responsibility for taxes owed on the income reported.
