Recap of the SALT Cap Workaround
In the past year, a multitude of states enacted pass-through entity tax (PTET) elections in response to the $10,000 state and local tax (SALT) deduction limitation that the Tax Cuts and Jobs Act (TCJA) put in place. With roughly 20 states that have a PTET election, and over half of these states enacting such workaround in 2021, these laws are designed to reduce the SALT cap effects on taxpayers without reducing states’ coffers.
Considering the IRS’s issuance of Notice 2020-75, which, for all intents and purposes, greenlighted the SALT workaround, it is anticipated as we flip the calendar to 2022 that the PTET tax trend will endure. An easier fix to this would be if Congress repeals the cap, but this doesn’t look probable, as its more likely taxpayers are left with a compromise of an increase to the cap. With the PTET here to stay, businesses are facing challenges navigating through PTET election decisions, as not only are the statutes complex, there is a lack of PTET uniformity amongst the states. However, having a universal approach in addressing each state’s PTET election decision enables a more streamlined approach when weighing decision making across a myriad of states.
Each state’s PTET election shares many common characteristics, which can be grouped into the following buckets:
- State taxable base
- Owner income offset
Issues that need to be examined regarding the election include not only whether the election is mandatory or elective, but also whether each PTE owner may decide to opt-in or out. If it’s elective, the following questions need to be considered:
- Is it revocable?
- Can a PTE make a retroactive election?
- Is the election made on an annual basis?
- Who is authorized to make the election (e.g., partners, officers)
When it comes to eligibility, issues to be considered include:
Which entity types qualify to make the election (e.g., LLC, partnership, S corporation)?
- Which eligible PTE owners can be included as part of the election?
- Can any ineligible owners implicate the election of the PTE?
State Taxable Base
Computation of the state taxable base requires analysis of the following:
- How state-sourced income is computed, including the consideration of which owners are subject to the PTET (e.g., individual, partnership or corporate partners)
Inclusion of income such as guaranteed payments
State modifications that may normally apply for a partnership/S corporation but may not apply for the PTET
State apportionment or sourcing rules that may differ from the partnership/S corporation return
The ability to use an alternative tax base
Owner Income Offset
The primary consideration with owner income offset is the mitigation of double state taxation at the owner level for the flow-through income, with states either providing a credit for the share of PTET paid by the entity to the owner or otherwise providing the owner an exclusion of the flow-through income. As more states have gone the route of a PTET credit, some issues that would need to be considered include:
If the PTET credit is a 100-percent credit for taxes paid, or does the state otherwise put a haircut on the amount of the PTET credit that is passed to the owner
Is the PTET credit refundable
Ordering of credit rules or other limitations on annual use of the PTET credit
On the latter, we have seen certain states like California limit the use of their nonrefundable PTET credit for the amount that the owner’s regular tax exceeds their Tentative Minimum Tax. As such, the value of the PTET with such rules may be significantly curtailed.
Separate and apart from this analysis, one of the common denominators that needs to be front and center with modeling out PTETs is the composition of owner (e.g., partner) demographics. As a PTET election shifts the tax burden from the owner to the PTE, nonresident owners no longer have a direct tax burden for their share of pass-through income. As such, in certain states, there may be the risk of loss of a resident credit to owners for such taxes paid by an electing PTE. A potential loss in a resident credit may supersede the benefit of a deduction for federal purposes. Possible planning to overcome this might include reorganizing the business into a multi-tiered structure, with the owners split at the upper tier based on their state residency, where the PTET is only elected at the entity comprising of respective state residents that are determined to benefit from such election.
Moreover, in many of the states that have enacted PTETs, the resident owner’s state may provide a resident credit if it’s deemed that the PTET in the electing state is “substantially similar.”
Looking Ahead to 2022
PTE elections undoubtably have many open questions, such as if the Biden administration will issue regulations forbidding the SALT workaround, if the IRS will allow investment partnerships that just hold investment assets to elect-in for the federal benefit and how narrowly states will view other states’ PTET as “substantially similar” when allowing a resident credit. However, what is clear is that the SALT workaround can be an attractive solution for many businesses. Even if Congress includes an enhanced SALT deduction in the Build Back Better bill, for many businesses the SALT workaround will remain vital in ensuring full SALT deductibility. When taking everything into consideration, the common issues of the SALT workaround remain the same across the state lines. That’s why for businesses tackling PTET election analysis, having a universal approach in addressing each state’s PTET enables a more streamlined approach when weighing decision making across a myriad of states.
James A. Bartek
James Bartek, CPA, is a partner in the state and local tax practice at Withum. He is a member of the NJCPA State Taxation Interest Group.