Pass-Through Entity Tax Laws: Weighing the Options for Your Business

The Rise of PTETs

The Tax Cuts and Jobs Act of 2017 limited the SALT deduction for individual taxpayers to $10,000. This particularly impacted owners of pass-through entities like partnerships and S corporations, whose income “passes through” to be taxed on the owners’ individual returns. Pass-through entity taxes emerged as a response, allowing these businesses to potentially avoid the SALT deduction cap.

How PTETs Work

The specifics of pass-through entity taxes vary by state, but the general principle is to shift the state tax burden for pass-through entity income from the individual owners to the entity itself. Eligible businesses can typically pay an entity-level tax on their income, with offsets for the owners at the individual level. These offsets often take the form of tax credits, deductions, or exclusions.

The IRS’s 2020 approval solidified pass-through entity taxes as a legitimate approach. This clarified that PTET payments by pass-through entities are deductible business expenses, and individual owners can avoid the SALT deduction limit when the entity pays these taxes.

State Variations and Considerations

While all pass-through entity tax laws acknowledge the IRS stance, there are significant state-by-state differences. Some states, like South Carolina, restrict PTET eligibility to specific income types. Other variations include:

• Election timing and requirements
• Revocability of an election
• Calculation of the entity-level tax base
• Application to tiered partnerships
• Treatment of excess pass-through entity tax credits

Business owners need to closely examine the PTET laws in each state their business operates in to determine if an election is advantageous.

Potential Benefits and Drawbacks

The ability to bypass the SALT deduction cap is a significant pass-through entity tax benefit. Additionally, PTETs might lower an owner’s adjusted gross income (AGI), leading to further tax advantages like deducting rental losses or contributing more to Roth retirement accounts.

However, PTETs aren’t without drawbacks. Nonresident owners, for instance, might face double taxation if their state of residence doesn’t offer credit for taxes paid to other states. Even with resident owners, pass-through entity taxes could:

• Increase cash flow burden due to estimated tax payments throughout the year
• Create a heavier compliance burden for businesses operating in multiple states with different PTET rules
• Reduce the federal qualified business income (QBI) deduction for owners
• Result in higher overall state tax liabilities

The Importance of Careful Consideration

The potential downsides of pass-through entity taxes, coupled with the ongoing discussions around SALT relief in Congress and the scheduled expiration of the SALT deduction cap in 2025 (unless extended), necessitate a cautious approach. Consulting with a tax advisor is crucial to determine if a PTET election aligns with your specific business situation and tax goals.