Pass-Through Entity Tax Update

HOST: Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters. Welcome to this edition of the Cherry Bekaert Tax Beat podcast.

HOST: We are taking another look at the evolving world of pass-through entity tax programs across various states. This is an ever-evolving world where new laws in 30 states and cities are driving partnerships, S corporations, and trusts to revisit their understanding of state income taxes.

HOST: These entities are looking for the best tax deductions at the federal level. However, I want to put a big caveat: you cannot ignore the consequences at the state level either, even though we are pursuing a federal tax deduction.

HOST: Joining the discussion today are my colleagues from our State and Local Tax (SALT) team: Kathy Stanton, the partner and leader of our firm's SALT practice, and Tony Conl, a manager within the practice and our leading consultant on pass-through entity (PTE) tax analysis. Welcome, Kathy. Where are you sitting today?

KATHY STANTON: I am doing great. I am sitting in the Washington, D.C. area, specifically Potomac, Maryland, this afternoon.

HOST: All right. What about you, Tony?

TONY CONL: Thanks, Brooks. I am coming to you live from Charlotte, North Carolina.

HOST: You have to love the Tar Heel State. As always, I have Sarah McGregor sitting in Greenville, South Carolina. How is life treating you today, Sarah?

SARAH MCGREGOR: Life is good in Greenville. It is hot, and it is good to have an indoor job.

HOST: It has been hot and steamy in Richmond, Virginia, but we have been getting a lot of rain that has been taking trees down. It has been interesting to go back and forth between the intense humidity and the rain.

HOST: Let’s move on to today’s topic. In December 2017, then-President Trump signed into law the Tax Cuts and Jobs Act (TCJA).

HOST: One of the key provisions in this law still making headlines today is the cap on the state and local tax (SALT) deduction. This is an itemized deduction for individual taxpayers on their Form 1040.

HOST: The limit enacted at that time, which remains true today, is $10,000. This includes not only state income taxes but all other property taxes and assorted state and local taxes that are otherwise deductible.

HOST: The larger tax-paying states, such as New York, New Jersey, and California, did not like this law at all. Some thought it might have been political retaliation, but in any case, states quickly started looking for workarounds.

HOST: An opportunity presented itself for pass-through entity owners when the IRS released Notice 2020-75. This paved the way for state and local income tax authorities to draft laws to directly tax the pass-through entities rather than the owners.

HOST: This created the PTE tax regimes. At the time this was issued, only seven states had enacted legislation for this type of entity-level tax.

HOST: As of August 1, 29 states and New York City have created laws in this space, and three more states have legislation pending. In addition to high-level statutes, we continue to see regulations, tax forms, and formal and informal guidance on these issues.

HOST: As we sit here today, federal legislation is moving through again. One of the key points that keeps coming up is whether someone will successfully lead the charge to get this $10,000 SALT cap repealed. It continues to be a big part of the behind-the-scenes discussion at the federal legislative level.

HOST: Kathy, what else can you tell us about this fast-paced change in PTE taxation?

KATHY STANTON: Who needs to repeal the tax if we are getting around it? Tax analysts recently caught wind of a provision within the Inflation Reduction Act to extend the SALT cap for another year.

KATHY STANTON: Instead of expiring in 2025, it would be extended to 2026. This was intended to help pay for a tweak regarding the Corporate Minimum Tax to help small businesses.

KATHY STANTON: They thought small businesses would be brought in through their investments and other flow-through entities. That did not actually make it in, as they decided to look at other sources, but it brings up the question of how much revenue they are really getting.

KATHY STANTON: When you look at the shopping list of what could earn revenue at the federal level, the SALT cap was a big-ticket item. Now that we have these workarounds, that revenue is going to be eroded.

KATHY STANTON: There was a huge difference where C corporations could deduct all their state income taxes but a pass-through entity could not. If you are not publicly traded and do not have to be a C Corp, you want to be a pass-through entity so you do not have a double layer of tax at the federal level.

KATHY STANTON: There is a big disparity between being a corporation and a pass-through entity in determining taxable income. With the majority of states having these workarounds, it is going to erode how much revenue the federal government receives.

KATHY STANTON: This raises interesting questions about whether it will be repealed and how much of a difference it will make. It also raises the question of whether the IRS will issue regulations to reverse what they said, which would be an incredible disaster.

KATHY STANTON: It is interesting to see how the politics play out. Democrats did not want to pass any bill without repealing that SALT cap, but they ended up compromising. In New York and California, certainly for business-type income, you can get around that SALT cap now.

HOST: Kathy, you mentioned further guidance. Has there been anything besides Notice 2020-75 that provides more certainty, or have there been any court decisions providing further support? Or is all of this state legislation hanging on the effect of this one notice?

KATHY STANTON: I have seen nothing in the committee talks or through the practitioner community.

HOST: It is interesting that all this legislation is being enacted for something we do not have total guidance on. This PTE election is aimed at getting a deduction at the federal level that you otherwise would not be able to get.

HOST: In a best-case scenario, we are talking about a 37% benefit for state taxes that would otherwise be disallowed. However, if you do not get an offset on your state taxes, particularly at your resident state tax level, then getting a 30% or 40% deduction is not a great deal when you lose the benefit of the full dollar of tax.

HOST: There are two primary frameworks that deal with this issue. Tony, why don't you walk us through the credit method and the income reduction method?

TONY CONL: States generally have two approaches for the SALT cap workaround. Most states are going to add back income taxes deducted on the federal return anyway, so for states, these are going to be revenue-neutral.

TONY CONL: The two different methods are what I have called the credit method and the income reduction method. Under the credit method, the pass-through entity pays an entity-level tax on the owner’s share of the income.

TONY CONL: That income is passed through to the owner in the typical fashion. For the owner on their personal return, their state income tax is computed, but then they receive a credit from the pass-through entity for the taxes paid at the entity level.

TONY CONL: This is usually a dollar-for-dollar credit that they use to offset that personal liability. The other way is the income reduction method.

TONY CONL: The pass-through entity pays that entity-level tax on the share of the state-source income. On the owner's personal return, they start with their full amount of federal taxable income, but the income that was taxed at the entity level is subtracted out.

TONY CONL: In a case where that owner only has income from a pass-through entity, the amount of taxable income might be zero after that subtraction. There does not need to be a credit to offset that tax because there may not be any taxable income.

HOST: So the net effect of both regimes should approximate a neutral effect at the state tax level. They are trying to put you in the same place you would have been without the PTE election, so you are getting a federal benefit without being hurt at the state level.

TONY CONL: That is exactly right, Brooks, but it does not always work out that way because we complicate everything at the state level. There are nuances where you could actually end up worse off, so you have to be careful and look at the details.

HOST: You and Tony have done a lot of consulting with companies about these complexities. What are you seeing?

KATHY STANTON: Pass-through entities have to be mindful of who is authorized to make the election in the partnership agreement. You can end up in a situation where some partners would benefit greatly while other partners in the same partnership would be harmed.

KATHY STANTON: When you have competing interests, the first concern is potential lawsuits. Who has the authority to make that decision, and what does the partnership agreement say? In some states, you might even have to have a vote to determine whether you make the election.

KATHY STANTON: Another component is that some states include a resident partner's entire income in the PTE tax base, as opposed to just the apportioned income. To get the benefit of the deduction for their entire income, you have to specifically allocate that tax expense to that partner.

KATHY STANTON: Otherwise, the whole partnership benefits from that deduction, not the specific partner whose income it pertained to. I am aware of one accounting firm where the partnership agreement does not allow those special allocations.

KATHY STANTON: With S corporations, you have to be careful not to create issues with a second class of stock. Regarding the timing of the federal deduction, it is a deduction within your K-1, line 1. It is netted and not a separately stated deduction.

KATHY STANTON: If you have purely investment income and make the PTE election, that tax may be an investment expense, which is not allowed as an itemized deduction. You only get an itemized deduction for business-type income, not investment income.

KATHY STANTON: You also have to look at multi-tier flow-through entities. Is it really a business or an investment expense at some point going up the tiers?

KATHY STANTON: From a financial statement impact standpoint, is this an income tax imposed at the entity level that you have to take into consideration for income tax provisions? You can get different answers with different states there.

TONY CONL: Since we last visited this issue, retroactivity has come up. Two states have passed legislation to allow for this election in prior tax years.

TONY CONL: Colorado passed legislation in 2021 for an election to go into effect for the 2022 tax year. However, they recently passed legislation to allow for an election starting in the 2018 tax year.

TONY CONL: Because these filing seasons have already gone by, they are doing a credit method to make this work for those retroactive years, even though they are an income reduction state for 2022 going forward.

TONY CONL: For Colorado and Virginia, we are on a delay for these retroactive tax years with a limited amount of information until 2023. Virginia passed theirs in April of this year, effective back to the 2021 tax year.

TONY CONL: However, for 2021 only, you will not be able to make the election until after October 15, 2023. This gives the Department of Revenue a year after the close of the filing season to figure out how to do this.

HOST: I can understand Colorado, but in Virginia, I don't think recreational cannabis is legal yet.

TONY CONL: They are just getting prepared. The complexity in one state alone is significant, let alone all the states having different rules.

TONY CONL: Another issue we are seeing is the base of income that the PTE tax is being calculated on. For residents, is the tax based on an apportioned state-source amount of income or all of their income?

TONY CONL: Maryland and California are both credit method states, but Maryland uses an apportioned amount for residents while California uses all income. Georgia and North Carolina are both income reduction method states but also have different approaches.

TONY CONL: Many states do not address guaranteed payments or retirement income specifically. Maryland states that Schedule K, lines 1 through 10 would be your base.

TONY CONL: Georgia regulations specifically exclude guaranteed payments to retired partners because federal law prohibits taxation of retirement income except by the state of residence.

TONY CONL: South Carolina only has the entity-level tax computed on active trade or business income. This will not include passive investment income, capital gains, or amounts reasonably related to personal services, which excludes most professional service partnerships.

HOST: What characteristics of a company make a good candidate for a pass-through entity election?

KATHY STANTON: Lots of income. The more income you have, the more state income tax you have, and the bigger your federal deduction.

KATHY STANTON: When you are looking at an asset sale, that would be a fantastic opportunity for PTE elections. If you have the business and the owners in the same state, you are going to get a credit or reduction of income so you are not harmed.

KATHY STANTON: You want to make sure that the owners will get that credit or reduction so they do not have to pay double tax. Generally, large income in a state that offers the election is where the biggest bang for the buck is.

HOST: Let's move to final comments. Tony, what words of wisdom would you like to share?

TONY CONL: Be very mindful of your election deadlines and any deadlines for making estimated payments. Alabama, Idaho, Louisiana, New Jersey, New York, and Oklahoma have specific dates you must meet.

TONY CONL: California has a strict June 15 deadline for a PTE to make an estimated payment. If that payment is not made, the entity cannot elect for the tax year.

TONY CONL: Be mindful that this is a fixed date regardless of whether it is a fiscal year or calendar year taxpayer. For a fiscal year taxpayer, that June 15 payment could actually come before the return deadline payment for the prior year.

KATHY STANTON: Look at your partnership agreements regarding who is authorized to make the election. In New York, it has to be an authorized person.

KATHY STANTON: Whether you are a cash or accrual basis taxpayer for federal purposes, make sure you are making these payments on a timeline that allows for that deduction for that tax year. Do not oversimplify this; every state is different, so please get your professional service provider involved.

SARAH MCGREGOR: This is still new to the tax compliance community and our clients. It bears a lot of attention as we finish extended 2021 returns and start planning for 2022. We need to invest time and effort to ensure companies take advantage of this terrific opportunity.

HOST: It is a terrific opportunity and also a place to miss opportunity as well. I keep getting overwhelmed by the complexity in this area.

HOST: No state is like another, which has been the mantra of SALT professionals forever. With that, let’s close this update on the PTE tax elections.

HOST: Thank you for listening. As a disclaimer, we are not providing tax advice on this podcast. Please consult with your tax advisor, hopefully at Cherry Bekaert Advisory, with your specific tax issues.

HOST: Check out the firm’s website at cbh.com for the latest guidance. This concludes today’s podcast. Please like, share, and subscribe.

HOST: Thank you, Kathy and Tony. Thank you to our listeners for spending your time with us. We truly appreciate it.