As soon as the Tax Cuts and Jobs Act was signed into law in 2017, state tax administrators, small business owners, and residents of states with high property tax and income tax rates began to look for ways to work around the Act’s $10,000 itemized deduction limit for state and local taxes (SALT). Typically, the owner of a partnership or S corporation pays income tax on the share of state income passed through to them from the business. However, over the last several months approximately 20 states have implemented new legislation to tax pass-through entities directly, rather than tax the individual owners. Tax Beat hosts, Brooks and Sarah, are joined by Cherry Bekaert’s Tax Partner and Leader of the State and Local Tax Practice, Cathie Stanton, and Tony Konkol, Manager with the Firm’s State and Local Tax Practice, to talk about these pass-through entity tax regimes. They cover the entities and owners who can take advantage of pass-through entity taxation and address issues to consider before electing in to this approach to state taxes.
Chapter Markers:
- 2:24: Overview
- 4:39: How states are responding to SALT Cap
- 8:52: IRS Notice 2020-75 paves the way for pass through entity taxation (“PTE”)
- 17:22: Issues to consider before making opting in to PTE
- 21:55: Methodologies and requirements for PTE
- 24:45: Limitations
- 28:45: Year-end tax planning and PTE
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HOST: Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters.
BROOKS NELSON: Welcome to the Cherry Bekaert Tax Beat podcast. Today, we're looking at the evolving world of pass-through entity tax programs in various states. New laws in at least 20 states are driving partnerships, S corporations, and trusts to revisit their understanding and consider new opportunities for state income taxes and related deductions.
BROOKS NELSON: Joining us today on this podcast are several colleagues. First, from our state and local tax team, Cathie.
CATHIE STANTOR: Hello. My name is Cathie Stantor. I lead the state and local tax practice for Cherry Bekaert, and I sit in the greater Washington, D.C., area.
TONY KONKOL: Thanks, Brooks. My name is Tony Konkol. I'm a manager in the state and local income and franchise practice at Cherry Bekaert, and I sit in the Charlotte, North Carolina, office.
SARAH MCGREGOR: Hello. This is Sarah McGregor. I work in the federal tax area, and I am in Greenville, South Carolina.
BROOKS NELSON: I'm Brooks Nelson, partner sitting in Richmond, Virginia.
BROOKS NELSON: Sarah McGregor, how's life treating you?
SARAH MCGREGOR: Life is good, Brooks. We are past the October 15 tax filing deadline, so almost all 2020 returns have now been prepared and processed. Our teams can finally start thinking in terms of 2021 being the current tax year.
SARAH MCGREGOR: The weather is excellent, and it's nice to go home at night without needing my car lights on. It's a good thing.
BROOKS NELSON: And your football team won an SEC game this past weekend.
SARAH MCGREGOR: Yes, they did. Thank goodness for Vandy.
BROOKS NELSON: I'm a contributing parent to the Vanderbilt football program, so I can't take too much credit. It was an exciting game.
BROOKS NELSON: All right, let's move on to today's topic and begin with some background about why this topic has so much relevance. In December 2017, then-President Trump signed into law the Tax Cuts and Jobs Act, commonly referred to as the TCJA.
BROOKS NELSON: One key provision limited the deduction for state and local taxes on individual federal income tax returns to $10,000. That $10,000 cap applies to income taxes, real estate taxes, and property taxes combined.
BROOKS NELSON: For many taxpayers, particularly those in states with higher income tax rates and owners of pass-through entities—LLCs, partnerships, S corporations, and trusts receiving K-1s—this felt punitive. C corporations generally pay state taxes at the entity level, so their owners were less directly affected.
BROOKS NELSON: There was a sense of inequity based on the form of entity used for business and between high-rate and low-rate states. Cathie, as our SALT expert, how have states and taxpayers responded to the SALT cap?
CATHIE STANTOR: It's been very interesting. Many Democratic-led states viewed the cap as a direct attack, particularly those with higher state income tax rates. They immediately began looking at workarounds to restore their constituents' positions prior to the limitation.
CATHIE STANTOR: One approach involved state-established funds, often for education, where an individual could contribute and receive a state income tax credit. The IRS had previously issued private letter rulings that allowed charitable contribution treatment for such donations in some cases, effectively permitting double benefits.
CATHIE STANTOR: States explored setting up these funds so taxpayers could get a state credit and still claim a charitable deduction. The IRS responded quickly, indicating you cannot claim a charitable deduction if you receive a quid pro quo, which undercut many programs.
CATHIE STANTOR: Another approach is imposing tax at the pass-through entity level. States like the District of Columbia and Tennessee impose tax at the entity level. The entity deducts that tax against ordinary income, and owners get an indirect benefit despite the SALT cap. That entity-level tax concept inspired the pass-through entity election trends.
BROOKS NELSON: So the purpose was to level the playing field between businesses taxed as C corporations and those taxed as pass-through entities.
BROOKS NELSON: Cathie, the IRS notice that came out quickly about charitable contributions hurt some existing programs. Can you expand on that?
CATHIE STANTOR: Yes. I spoke with attorneys involved in setting up those programs, and some southern states relied heavily on them for education funding. The IRS guidance constrained the charitable deduction approach. In some limited circumstances, corporations might still contribute and get a benefit, but overall it was a significant setback for those programs.
BROOKS NELSON: To be clear, the IRS guidance didn't absolutely prohibit the approach; it required taxpayers to reduce the charitable deduction by the amount of the state credit, which reduced the attractiveness of the strategy. They also provided a 15 percent de minimis rule, so some programs could still qualify under that threshold.
BROOKS NELSON: Tony, more recent IRS guidance—specifically Notice 2020-75—has been described as more favorable. Share your thoughts on that.
TONY KONKOL: Notice 2020-75, issued on November 9, 2020, says a partnership or S corporation computing its non-separately stated taxable income or loss can deduct state and local taxes imposed on its net income for the tax year.
TONY KONKOL: The notice indicated the IRS would propose regulations for the mechanics of how an entity can take the deduction. However, nearly a year later, we still haven't seen proposed regulations or further guidance.
BROOKS NELSON: I imagine practical issues have surfaced as states implement these elections. Tony, how have states approached pass-through entity level taxation, and are there trends?
TONY KONKOL: Since the notice, there's been an uptick in legislation. About a year ago there were roughly seven states with such mechanisms; now there are about 20, with another three considering legislation.
TONY KONKOL: Connecticut was the first to pass something like this in 2018 and made it mandatory. Since then, most states have opted for an elective model. Many states will likely continue with an elective mechanism rather than a mandatory one.
BROOKS NELSON: Cathie mentioned the distinction between Tennessee and neighboring Georgia. Tennessee doesn't tax a lot of earned income, whereas Georgia does. A pass-through entity level tax can have very different impacts depending on where owners reside.
CATHIE STANTOR: Absolutely. Each state has different eligibility rules and mechanics, which adds complexity. Some states require only individuals as owners, while others permit tiered pass-through entities and different owner types.
CATHIE STANTOR: A key issue is where owners reside. For the pass-through entity election to effectively circumvent the $10,000 SALT cap, the state imposing the entity-level tax must provide a credit to the individual owner for taxes paid at the entity level. States generally start with federal adjusted gross income, so the individual will still report the income, and the credit prevents double taxation.
CATHIE STANTOR: For example, Maryland enacted a pass-through entity election that allows any eligible pass-through entity in the state to elect to be taxed at the entity level. Maryland residents then receive a credit on their individual returns to prevent double tax.
CATHIE STANTOR: Problems arise when owners live in neighboring jurisdictions that may not provide reciprocal credits. In the greater D.C. area, for instance, owners in D.C. or Virginia who are partners in a Maryland pass-through entity could face double taxation if their resident state does not grant a credit for taxes paid to Maryland.
CATHIE STANTOR: Virginia and D.C. have been slow to provide guidance on how they will treat such credits. In some cases, Maryland's election may be revocable, allowing amended returns if other states take an unfavorable position, but many states make the election irrevocable.
CATHIE STANTOR: Other issues include conflicts among owners: an election can benefit some owners and harm others, depending on their residency and tax positions. Partnerships need to determine who is authorized to make the election and may need to revise partnership agreements accordingly.
BROOKS NELSON: To recap reasons not to make the election: resident states might not allow a credit, conflicting owner interests, the potential repeal of the $10,000 SALT cap in the future, and complexity across different state rules. Are there other considerations?
CATHIE STANTOR: Yes. If you're selling your business and the sale results in significant income—often from goodwill and other intangibles—you should evaluate these elections carefully. The benefit is at the federal level because the entity-level tax paid can be deductible for federal purposes, producing significant federal tax savings.
BROOKS NELSON: Sarah, from a federal perspective, what issues need to be considered for S corporations and partnerships making these elections?
SARAH MCGREGOR: For S corporations, disparities can arise between shareholders who are residents benefiting from the credit and nonresidents who do not. That raises questions about distributions and whether such differences create an impermissible disparity that could jeopardize S corporation status.
SARAH MCGREGOR: Typically, these issues are addressed when composite returns or withholding apply, but a state-level entity tax is a deduction on the tax return rather than a cash distribution, which complicates matters.
SARAH MCGREGOR: For partnerships, waterfall distributions and income allocation provisions may interact with elective entity-level taxes. Partnership agreements should be reviewed to determine how an election affects partner allocations and distributions.
SARAH MCGREGOR: The new partnership audit rules add another layer. The partnership representative would be in charge of audits and any assessments, so if the deduction is disallowed later, the partnership could be on the hook.
SARAH MCGREGOR: Despite the complexities, getting a full federal tax deduction for state-level taxes paid by the entity is attractive.
BROOKS NELSON: Tony, what are some of the mechanics and deadlines for these elections? Must they be made on the tax return, or by year-end?
TONY KONKOL: Each state has unique rules. Generally, two methodologies are emerging: one where the entity pays the tax and owners receive a credit, and another where the owner does not receive a credit but the owner's individual taxable income is reduced by the amount of income taxed at the entity level.
TONY KONKOL: Most states follow the credit methodology. Only a few reduce owner income directly. Deadlines can be complex. For example, New York required the 2021 election by October 15, 2021, and going forward the election must be renewed annually by March 15.
TONY KONKOL: Some states let you elect on the return itself, so you must track regular and extended due dates. For multi-state, multi-partner entities, tracking elections and deadlines across states can be challenging.
TONY KONKOL: Estimated payments are another issue. If the entity is required to make payments but individual members already made estimated payments, there may be cash timing issues. First-year filings can result in taxpayers temporarily overpaying until returns are reconciled.
TONY KONKOL: Many states make the election irrevocable. Michigan has proposed rules where an election is irrevocable for the tax year and binding for the next two tax years. That raises concerns when partners change or capital structures shift.
TONY KONKOL: Not all members may be eligible. Some states allow partnerships or S corporations to make the election while carving out non-eligible members. Tax rates also matter: states with progressive brackets may set a flat entity-level rate that differs from individual marginal rates, potentially resulting in higher or lower taxes at the entity level.
TONY KONKOL: Credits for resident taxpayers can be contentious. Some states, like Maine, have declared they will not grant a credit for certain other states' entity-level taxes. Connecticut and Massachusetts have applied credits that are a percentage—such as 90 percent—of tax paid, rather than a full dollar-for-dollar credit.
CATHIE STANTOR: Reducing the credit percentage is a straightforward way for states to raise revenue.
BROOKS NELSON: Cathie, with year-end planning in mind, what should pass-through entities be doing now?
CATHIE STANTOR: First, estimate your state taxable income for the various states in which you have activity. Identify states where you have significant taxable income and determine whether they have a pass-through entity election and whether you're eligible.
CATHIE STANTOR: Review the effective dates, eligibility rules, deadlines, and payment mechanics. Remember that the entity generally must make the payment to obtain the federal deduction—individual estimated payments won't substitute.
CATHIE STANTOR: If you expect to sell your company or have a large taxable event, analyze these elections now because timing and calculations can significantly affect federal tax outcomes.
BROOKS NELSON: Sarah, any final comments?
SARAH MCGREGOR: It's complicated. Each business and individual owner must examine the specific state rules to determine the optimal approach. Keep in mind these provisions currently run through the end of 2025 and could expire then.
CATHIE STANTOR: There may be benefits beyond 2025 if the entity-level tax circumvents the alternative minimum tax rules or other provisions. The potential benefits can be substantial, so a careful analysis is warranted.
SARAH MCGREGOR: You're talking about going from effectively no deduction to a scenario where each dollar of tax above the $10,000 cap yields significant federal tax savings.
BROOKS NELSON: Thank you for joining today's discussion on the $10,000 SALT cap workaround for pass-through entities. A quick disclaimer: we are not providing tax advice on this podcast. Please consult your tax advisor, preferably at Cherry Bekaert, about your specific tax issues or to discuss information from today's podcast.
BROOKS NELSON: Check the firm's website at cbh.com for the latest guidance and materials on this and other topics. This concludes today's podcast. Please like, share, and subscribe.
BROOKS NELSON: Thank you, Cathie and Tony. Thank you, Sarah. Thank you to our listeners for spending your time with us. Let's call it a day.
