Tom Talks Taxes - January 21, 2022
What you need to know about state pass-through entity tax regimes
Many states have passed laws allowing for pass-through entities (partnerships and S corporations) to elect into paying an entity-level income tax to facilitate owners bypassing the individual state and local tax deduction cap on Schedule A. While each state’s regime is unique, they generally have these four common features:
The entity elects to pay state income tax at the entity level. This election is usually done 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 non-separately 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.
The entity allocates a pro-rata state tax credit to the owners which reduces the state income tax liability on the owner’s state income tax return.
The IRS blessed this arrangement in Notice 2020-75; therefore, many states have enacted a pass-through entity tax regime, including California and New York. Even low tax states, such as Arizona, have enacted such regimes.
Any pass-through entity who has either owners residing in a state or income apportioned to a state should make a determination about whether or not to elect into that state’s pass-through entity tax, if there is one.
When making the election decision, it is critical to actually run the numbers to determine the tax benefit, if any, to the business owners. The following four considerations will be key:
The state income tax paid by the entity reduces federal AGI in addition to taxable income; therefore, the owners may unlock various other tax benefits that are AGI-dependent. For example, in tax year 2021, the 2021 recovery rebate credit and the enhanced child tax credits can be boosted significantly over a narrow range of AGI.
The reduction in net pass-through income does reduce qualified business income for purposes of the §199A deduction, so the cost of that lost federal tax deduction must be factored into the analysis.
The entity generally deducts the state income tax in the year the tax is paid; therefore, assuming any required estimated tax payments are made, the entity may have flexibility as to what tax year the state income payments are made and, thus, the tax year in which the federal pass-through income is reduced.
If the owner can fully use the allocated tax credit on its state income tax return, then the election merely shifts the owner’s tax liability to the entity. If the owner cannot fully use the allocated tax credit, then it may be lost or carried forward, and that cost needs to be factored against any potential federal tax savings.
A closing thought: this is a significant increase in the amount of work performed for pass-through entities. The decision to make this election, the estimated net tax savings from the election, and computing any required estimated tax payments is not free work included with tax return preparation. This is ongoing tax planning work that provides value to the client and should be charged for appropriately.
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