Editor: Kevin D. Anderson, CPA, J.D.
States imposing entity-level taxes on passthrough entities is not a new phenomenon. The District of Columbia, New Hampshire, New York City, Tennessee, and Texas have imposed mandatory entity-level income or franchise taxes on passthrough entities for years. While most states have conformed to federal passthrough tax treatment, federal tax reform has caused additional states to consider passthrough-entity-level taxes.
Why would a passthrough entity voluntarily elect to be taxed at the entity level? Like many other pressing state income tax issues that have arisen since December 2017, the answer is federal tax reform and the $10,000 state and local tax (SALT) deduction limitation. As a result, state passthrough entity taxes are now viewed as a workaround to this limitation. Although Connecticut joined the mandatory passthrough entity tax states in 2018, a number of other states have recently enacted elective passthrough entity tax regimes as a federal workaround. This discussion examines those elective passthrough entity tax enactments.
Before passage of the law known as the Tax Cuts and Jobs Act, P.L. 115-97, individuals who itemized deductions could deduct their state tax payments in full on Schedule A, Itemized Deductions, of their federal Form 1040, U.S. Individual Income Tax Return. The premise of the elective passthrough entity tax workaround is simple in theory. By imposing an income tax directly on the passthrough entity, which as a trade or business is not limited in the amount of state taxes that it can deduct for federal purposes, a state's tax on passthrough entity income now becomes a deduction for the passthrough entity for federal income tax purposes.
States that have created passthrough entity elections take either of two general approaches to the mechanics of this tax scheme. New Jersey and Rhode Island allow the individual owners of the passthrough entity an income tax credit for their share of the passthrough entity tax paid by the entity. Conversely, Louisiana, Oklahoma, and Wisconsin reduce the owners' state taxable income by the income included and taxed on the passthrough entity's return.
Louisiana enacted an optional passthrough entity tax in June 2019, effective for tax years beginning on or after Jan. 1, 2019 (S.B. 223; 2019 La. Act 442, codified atLa Rev. Stat. §42:287.732.2). The election is available for S corporations and entities taxed as partnerships for federal income tax purposes. If a passthrough entity makes the election, then it is taxed as if it were a C corporation for federal tax purposes. The electing passthrough entity is taxed pursuant to a graduated rate structure. The election is not available to passthrough entities filing a partnership composite return.
To make the election, owners holding more than 50% of the ownership interests in the passthrough entity (based on capital account balances) must approve the election. An election is timely made at any time during the preceding tax year or by the 15th day of the fourth month after the close of the tax year in which the election is first effective. Based on recently issued regulations, Louisiana began accepting elections on Feb. 1, 2020, for tax years beginning on or after Jan. 1, 2019. The passthrough entity election remains effective for succeeding tax years, until it is revoked. To terminate the election, the passthrough entity must apply to the Department of Revenue with written consent of members owning more than 50% of the ownership interests. An election may also be terminated for other reasons, such as a "significant change in federal law."
The owners of an electing passthrough entity exclude their share of net income or loss from their Louisiana individual tax returns in lieu of a tax credit for their share of the Louisiana passthrough entity tax.
New Jersey is the most recent state as of this writing to enact a passthrough entity election (S.B. 3246; 2019 N.J. Laws c. 320, §3, codified atN.J. Rev. Stat. §54A:12-3). Electing passthrough entities are subject to the business alternative income tax (BAIT). Effective for tax years beginning on or after Jan. 1, 2020, a passthrough entity with at least one member who is liable for New Jersey gross income tax may elect to be liable for and pay the BAIT in a tax year. Eligible passthrough entities include partnerships, S corporations, and LLCs with at least two members.
The BAIT is imposed on a tax base that is equal to the sum of each member's share of the passthrough entity's "distributive proceeds" attributable to the passthrough entity for the tax year. Distributive proceeds are defined as the net income, dividends, royalties, interest, rents, guaranteed payments, and gains of the passthrough entity derived from or connected with sources within New Jersey upon which the New Jersey gross income tax would be imposed if the passthrough entity were an individual taxpayer. The graduated tax rates for the new BAIT range from 5.675% to 10.9%.
The election must be made annually by the 15th day of the third month following the close of the tax year. The election cannot be made retroactively. To make the election, each member of the passthrough entity must consent at the time the election is filed. Alternatively, the election can be made by any officer, manager, or member who is authorized to make the election on behalf of the passthrough entity. The election is not binding. Finally, if the members decide to revoke the election, that revocation must be made on or before the original due date of the passthrough entity's return for the tax year in which the revocation is to be effective.
If a passthrough entity makes the BAIT election and is also engaged in a unitary business with a corporate member, then the passthrough entity must be included in the member's New Jersey combined return.
Noncorporate members of a passthrough entity making the election are allowed a refundable New Jersey credit equal to their pro rata share of the tax paid by the passthrough entity. New Jersey residents are also allowed a credit against their New Jersey gross income tax due for the amount of any other state passthrough entity tax that the director determines is substantially similar to the New Jersey BAIT.
A corporation that owns an interest in a passthrough entity making the BAIT election is allowed a credit against both the corporation business tax (CBT) and the temporary surtax equal to its pro rata share of the BAIT tax paid by the passthrough entity. The credit cannot reduce the CBT or surtax liability below the New Jersey minimum tax, but it can be carried forward for up to 20 years. If the passthrough entity is only unitary with the corporate member but not that corporate member's combined group, then the credit is not shareable with other New Jersey combined group members.
Oklahoma enacted the Pass-Through Entity Tax Equity Act of 2019, effective April 29, 2019 (H.B. 2665; Okla. L. 2019, c. 201, codified at Okla. Stat. tit. 68, §2355.1P-1 et seq.). For tax years beginning on or after Jan. 1, 2019, passthrough entities can elect to be taxed at the entity level. Eligible entities include partnerships and S corporations. A single-member LLC (SMLLC) that is disregarded and included on its member's federal tax return is not eligible to be an electing passthrough entity. To make the passthrough entity election, the SMLLC would have to make an S corporation election for federal tax purposes and then an Oklahoma passthrough entity tax election.
Different tax rates apply to the electing passthrough entity, depending on the type of members. For income distributable to individuals, the highest individual income tax rate applies, 5% for 2019. For income distributable to a corporate member, the corporation income tax rate applies, which is 6%. Thus, the passthrough entity's tax liability is determined by aggregating the amounts of tax based on the different rates, as applicable.
To make the election for the 2019 tax year, Oklahoma Tax Commission (OTC) Form 586, Pass-Through Entity Election Form, must have been filed by June 28, 2019. For tax years beginning on or after Jan. 1, 2020, the election must be made at any time during the preceding tax year or two months and 15 days after the beginning of the tax year. The election is binding until revoked. The electing passthrough entity can revoke the election by completing Part 2 of Form 586. If the passthrough entity files the revocation within two months and 15 days after the beginning of the passthrough entity's tax year, it is effective as of the first day of the tax year; otherwise, it is effective as of the first day of the following tax year. The OTC may also revoke the election if tax required to be paid by the passthrough entity is not paid when due.
An election by a passthrough entity revokes any election to file an Oklahoma composite partnership return or the requirement that an S corporation must report and pay income tax on behalf of its nonresident shareholders. Nonresident members of an electing passthrough entity are not required to file an Oklahoma individual income tax return if their only source of Oklahoma income is one or more electing passthrough entities.
The electing passthrough entity is required to make extension payments, file returns, and pay the tax due by the same due dates as C corporations. The electing passthrough entity may carry back and forward any net operating losses it generates. Tax credits generated by the passthrough entity stay at the entity level and cannot be allocated to the members.
Similar to Louisiana, Oklahoma's passthrough entity tax election does not provide a corresponding income tax credit for the members of the passthrough entity. Instead, the members subtract any item of gain or add any item of loss that was allocated to them for federal tax purposes to their federal adjusted gross income (AGI).
Rhode Island enacted an annual passthrough entity tax election effective for tax years beginning on or after Jan. 1, 2019 (H.B. 5151; R.I. L. 2019, c. 88, art. 5, codified at R.I Gen. Laws §44-11-2.3). The tax rate is 5.99%. Eligible entities include S corporations, partnerships, trusts, LLCs, and other entities not taxed as a corporation for federal tax purposes. For the 2019 and 2020 tax years, the 5.99% rate on electing passthrough entities is the same as Rhode Island's highest individual tax rate. It is, however, lower than the 7% corporate tax rate.
To make the election, a passthrough entity must file Form RI-PTE, Pass-through Entity Election Tax Return, on or before the 15th day of the third month following the close of the tax year. If the election is made, the passthrough entity will not have to comply with nonresident member withholding requirements. Rhode Island does not address election revocation.
When owners calculate their Rhode Island income tax, their distributive share of income remains in their federal AGI starting point upon which their Rhode Island tax is determined. However, the owner receives a Rhode Island tax credit equal to the owner's share of the entity-level tax payment made by the electing passthrough entity.
Wisconsin was the first state to enact an elective passthrough entity tax in 2018 (S.B. 883; Wis. L. 2017, Act 368, codified at Wis. Stat. §71.05(6)(a)(14)). For the 2018 tax year, only S corporations were allowed to make the election. Beginning with the 2019 tax year, partnerships can make the election. If a passthrough entity makes the election, it will be taxed at a 7.9% rate on its net income apportioned and allocated to Wisconsin. Currently, the highest individual income tax rate in Wisconsin is 7.65%; therefore, an analysis should be completed to determine whether the potential tax savings outweigh the increased Wisconsin tax liability.
Members who hold more than 50% of the passthrough entity's ownership interests must consent to the election. The nonbinding annual election must be made on or before the extended due date of the passthrough entity's return for each tax year. Revoking the election also requires the consent of members who hold more than 50% of the passthrough entity's ownership interests. The revocation must be made on or before the extended due date of the return.
The character of income, along with the rules of apportionment and allocation, remains the same as if the election were not made. That is, the passthrough entity will apply the Wisconsin corporate income tax apportionment provisions. The effect of the passthrough entity's income, gain, loss, etc., on a passthrough entity owner's tax basis in the owner's interest is determined as if the passthrough entity election had not been made. When calculating their Wisconsin AGI, owners exclude their proportionate share of all items of income, gain, loss, or deduction.
The passthrough entity may not carry over losses. Tax credits available to the passthrough entity's owners cannot be used to offset the entity's passthrough entity tax. The only tax credits allowed the passthrough entity are net income or franchise taxes it paid another state, including income taxes paid on behalf of its owners that are Wisconsin residents on other state composite tax returns. However, the other state tax credits are limited to the Wisconsin 7.9% rate.
If a passthrough entity fails to pay the amount of tax owed with respect to income as a result of the election, the Wisconsin Department of Revenue may collect the amount from the owners based on their proportionate share of the passthrough entity's income.
Passthrough entity tax elections will likely be enacted by additional states as a workaround to the federal SALT deduction limitation. It might be beneficial to make an entity-level election in one or more of the five states discussed above. But, before making an election, tax advisers should complete a thorough analysis. Do not simply calculate the individual tax savings at the federal level by only considering the workaround to the $10,000 SALT cap in the electing state.
Kevin D. Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.