Several states, including Alabama, Arkansas, Arizona, California, Colorado, Connecticut, Georgia, Idaho, Illinois, Louisiana, Maryland, Minnesota, New Jersey, New York, Oklahoma, Rhode Island, South Carolina, and Wisconsin, have passed legislation either requiring or allowing entities classified as partnerships or S corporations for tax purposes (Pass-Through Entities) that file income tax returns in those states to elect to pay income tax at the entity level rather than at the individual owner level (such tax, a pass-through entity tax or PTE Tax). Most recently, the Massachusetts legislature overrode Governor Baker’s veto of HB 4009 on September 30, 2021, enacting an elective PTE Tax.
The Tax Cuts and Jobs Act of 2017 added Section 164(b)(6) to the Internal Revenue Code of 1986, as amended (the “Code”), to limit the amount an individual taxpayer may deduct annually for state and local taxes to $10,000. Since then, many states have considered how to amend state tax laws to allow taxpayers to bypass this change and deduct more than $10,000 for state and local taxes paid. In 2020, the Internal Revenue Service (IRS) released Notice 2020-75, which concluded that an owner’s proportionate share of PTE Tax paid by a Pass-Through Entity (and generally reported on a Schedule K-1) is not subject to the $10,000 limitation on such owner’s individual U.S. federal income tax return. Taxpayers can rely on IRS Notice 2020-75 before issuing any proposed regulations and can rely on any proposed regulations prior to the issuance of final regulations. Accordingly, where a Pass-Through Entity pays PTE Tax, owners may be able to deduct state and local taxes in excess of the $10,000 limitation.
Since the issuance of Notice 2020-75, states have implemented various forms of PTE Tax regimes. An elective PTE Tax typically works as follows: (1) the Pass-Through Entity elects to voluntarily pay tax at the entity level and (2) the owners of the Pass-Through Entity would still report their share of allocable income on their individual state tax returns, but they would be granted a full or partial credit against their individual tax liability for their allocable share of PTE Tax incurred at the entity-level. Some states allow any excess credit to be refunded, while others may provide a carryforward of excess credit to a future taxable year. In states providing a full refund of excess PTE Tax paid, the aggregate state tax liability to an owner of a Pass-Through Entity (taking into account both the PTE Tax and the owner-level tax) may not differ from the amount of tax that would be incurred by the owner in the absence of a PTE Tax. But from a U.S. federal income tax perspective, the PTE Tax may be deductible, thereby reducing the owner’s U.S. federal income tax liability.
Business owners considering the disposition of their business should consider whether an election to pay PTE Tax could offset some taxable gain from the sale with a deduction or credit for state and local taxes. Pass-Through Entities and their owners should consult with advisors and carefully consider the tax consequences of structuring the sale of a business as an asset sale for U.S. federal income tax purposes.
Additionally, Business owners and Pass-Through Entities filing income tax returns in one or more states should consider how each state’s PTE Tax operates. For example, Massachusetts allows taxpayers to elect to pay PTE Tax at a rate of 5 percent of “qualified income taxable in Massachusetts.” See Chapter 63D of the Mass. Gen. Laws. Once made, the election is irrevocable and binding on all members of the Pass-Through Entity. “Qualified members” of the Pass-Through Entity can claim a refundable credit against their Massachusetts personal income tax. The credit equals a qualified member’s proportionate share of tax due and paid by the Pass-Through Entity multiplied by 0.9. The election is available for tax years beginning on or after January 1, 2021, but is not available in a taxable year in which the $10,000 limitation under Section 164(b)(6) of the Code has expired or is otherwise not in effect.
For businesses operating in multiple states, it is important to consider the PTE Tax regimes in each applicable state. In this regard, we note there may be a risk in some states that PTE Taxes paid by a Pass-Through Entity in one state may not be creditable (or may only be partially creditable) against an individual owner’s state income taxes imposed by another state where the owner is resident.