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Tom Talks Taxes - December 19, 2022
Planning considerations for state pass-through entity taxes
Over thirty states have implemented a pass-through entity tax (PTET) system in the last few years. This is in direct response to Notice 2020-75, which gave basic information on how the IRS views these arrangements. The notice says that future regulations are forthcoming; further guidance is sorely needed as some nuances are unanswered.
PTET systems allow pass-through entity business owners to deduct the state and local income taxes attributed to their net business income. This helps to provide parity with the C corporation, in which all state and local income taxes are generally deductible for federal tax purposes. Without a pass-through entity tax system, many owners would get a reduced or eliminated individual state and local income tax deduction due to the $10,000 deduction limitation in place through tax year 2025.
Assisting clients with PTET planning is essential while these systems are in place.
There is not one standard PTET system; there are over thirty different systems. To do PTET planning, you must know the rules particular to the state where you live and all the states where your pass-through entities conduct business.
Most PTET systems follow these four general principles:
The entity elects to pay state income tax at the entity level. This election is usually made on an annual basis.
The entity pays state-level income tax, either with the tax return or by making estimated tax payments.
The entity’s federal pass-through nonseparately stated income is reduced by the state tax deduction in the year the state income tax is paid, leading to a federal reduction in both adjusted gross income (AGI) and taxable income. It is not coded on Schedule K-1 as a separately stated tax payment.
The entity allocates a pro-rata state tax credit to the owners, reducing the state income tax liability on the owner’s state income tax return. The credit is usually nonrefundable.
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Let’s use Sal, who is a 100% owner of an S corporation, as an example. In tax year 2022, Sal’s S corporation has nonseparately stated income of $100,000. Sal lives and works in a state with a PTET, and the tax rate is 6%. He does not itemize deductions on his federal tax return, and he is in the 24% federal tax bracket.
Assuming Sal’s S corporation pays a total of $6,000 during tax year 2022, the S corporation’s 2022 federal taxable income is reduced to $94,000.
Reducing Sal’s taxable income on his Form 1040 will reduce his tax liability and affect his §199A deduction, as that deduction is tied to Form 1040 taxable income. If a taxpayer is over the §199A taxable income threshold, reducing taxable income may boost the §199A deduction since the §199A deduction limitations will have a reduced effect.
Sal is under the §199A threshold, so the PTET deduction reduces his §199A qualified business income, which will reduce his §199A deduction.
For Sal, a back-of-the-envelope estimate of the federal tax savings from electing into the PTET is $1,152:
$1,440 (24% of $6,000), less
$288 (24% of 20% of $6,000) from the reduced §199A deduction.
That’s just the start of the federal tax savings, as the PTET deduction also reduces Sal’s adjusted gross income (AGI) by $6,000. Dozens of tax provisions are tied to AGI, and a lower AGI can:
Increase other deductions, such as the student loan interest deduction,
Increase other credits, such as the saver’s credit or the lifetime learning credit,
Reduce exposure to additional taxes, such as the net investment income tax, and
Reduce Medicare premiums if age 65 or older and Income Related Monthly Adjustment Amounts (IRMAA) applies.
In a partnership, a PTET deduction also reduces self-employment tax for a general partner, who is subject to self-employment tax on all nonseparately stated business income of the partnership.
Another essential consideration for PTET planning is the timing of the deduction. For a cash basis taxpayer, the tax is deductible when paid, including reasonably determined estimated tax payments. See Rev. Rul. 71-190; Rev. Rul. 82-208; Estate of Lowenstein v. Comm., 12 T.C. 694 (1948). When payments are required is dependent on the state’s PTET system.
The time value of money concept usually means that a taxpayer should accelerate deductions to the soonest tax year possible; however, if a taxpayer has very different tax situations in adjoining tax years, it may make sense to defer payment to that later year.
For example, if Sal were in the 32% tax bracket in tax year 2023, deducting the $6,000 payment in tax year 2023 would save an additional $480 in federal income tax. In addition, since Sal would be over the §199A threshold in tax year 2023, the federal taxable income reduction may increase his §199A deduction instead of lowering it, as it did in tax year 2022. In addition, the decrease in AGI in a higher AGI year may lead to more downstream federal tax savings than in a lower AGI year.
When discussing PTET planning, we must pay attention to the state income tax side of the equation. The PTET tax liability generates an income tax credit; if that credit is fully utilized in that tax year, there is no net change in the owner’s state income tax liability. If the credit is carried forward and eventually partially lost, the taxpayer paid more state income tax under the PTET than they would have otherwise.
As you can see, PTET planning is not a five-minute exercise only involving calculating estimated tax payment amounts. It is high-end tax planning requiring detailed projections and ongoing, thoughtful decisions.
Even if you don’t do year-round tax planning for your clients, you should provide PTET planning to every pass-through entity client if they operate in a state with a PTET system. Yes – each one – even if the decision is to not elect into the PTET system. The choice must be an annual informed choice.
A great example is a pass-through entity with a one-off, very high-income year. Suppose you assume “business as usual” for that client and do not know about the income change. In that case, it may be too late to elect into the PTET system by the time you prepare the return, or the taxpayer may face significant estimated tax penalties for failing to make prepayments of the projected entity tax.
I recommend bundling PTET planning as part of your base pass-through entity tax return preparation price and then charging a fair value-based price for all the services you provide the client as part of that bundle. Moving to this model would be an excellent opportunity to reflect on what services beyond tax preparation you provide entity clients currently and what the value of those services is to the client. Is your price commensurate with the services you offer?
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