Editor: Anthony Bakale, CPA
Rarely does new state and local tax legislation cause a sigh of relief for taxpayers or practitioners. While the parties responsible for tax reform may lead with best intentions for easing the burden of those involved, a new state or local tax law typically signals yet another layer of difficulty tacked onto an already difficult subject. And to make matters worse, when thinking of the number of domestic state and local tax jurisdictions, one quickly realizes no two governing bodies are likely to implement or execute new tax laws consistently across the landscape.
That is the case for state passthrough entity (PTE) "taxing" elections. Beginning in 2018, the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, introduced a cap of $10,000 for itemized deductions of state and local taxes (SALT), dramatically affecting certain taxpayers. The cap led some taxpayers to contemplate changing their state of residency because their states impose a higher-than-average tax rate on personal income. States' reactions were quick in a few cases, but many awaited guidance, which the IRS eventually offered in Notice 2020-75.
Fast-forward four years, and 27 states along with one other jurisdiction have enacted a version of a PTE taxing election with another four proposals in the works. This election pushes the responsibility for paying SALT income taxes on flowthrough income up to the PTE and allows it to deduct those taxes at the entity level under the provisions of Notice 2020-75, simultaneously providing a credit to the owners to avoid double taxation. Unfortunately for the practitioner, the only thing that can be relied on consistently regarding state PTE elections is inconsistency.
As a result, practitioners may face a difficult analysis in helping their clients understand their possible PTE election opportunities. A single state election can be complex on its own, let alone navigating the differences among multiple states' elections on seemingly minor mechanics that can have broad ramifications. To avoid increasing a taxpayer's liability, practitioners should consider the following steps, and discuss them with clients, before making a state PTE election.
Step 1: Determining the opportunity
Which states currently offer a PTE election? With so much information available on the topic of PTE elections, it is important to determine what opportunities are available to taxpayers prior to diving into the details. As previously mentioned, 32 state and local jurisdictions have taken some form of action, including Alabama, Arizona, Arkansas, California, Colorado, Connecticut, Georgia, Idaho, Illinois, Kansas, Louisiana, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, New Jersey, New Mexico, New York, North Carolina, Oklahoma, Oregon, Rhode Island, South Carolina, Utah, Virginia, Wisconsin, and New York City (proposed in Iowa, Missouri, Ohio, and Pennsylvania).
Does my entity qualify for a PTE election? Generally, partnerships and S corporations (and occasionally trusts) are among the entity types able to make such an election. However, many exceptions can restrict eligibility. Publicly traded partnerships, multitiered structures, single-member LLCs, disregarded entities, and sole proprietorships are among a few examples of entities that can complicate a state PTE election, whether they are the desired electing entity or part of the electing entity's ownership group. A review of the ownership group will play an important role in the election process, as having certain owner types will explicitly disqualify entities from participating in a PTE election. Additionally, each state's election may depend on whether all owners are included in the return or whether certain nonqualifying owners may be excluded from the PTE tax base.
Window of opportunity for a PTE election: Currently, the SALT cap is set to expire after 2025. Many state elections follow a window of availability that is tied to the existence of the SALT cap, and any increases to or repeal of the SALT cap may eliminate a state PTE election. Generally, state PTE elections are completed on an annual basis and are irrevocable once elected.
Estimating the benefit of a PTE election: To determine the potential benefit of a PTE election, one must look beyond simply applying the PTE rate against taxable income. The analysis requires a thorough evaluation of the entity's performance, including future initiatives to avoid time constraints on any PTE election. Factors that tend to suggest a PTE election could be beneficial include that the taxpayer has high levels of taxable state income largely sourced to PTE states, the owner resides in a PTE state, and the owner's home state includes PTE credits in its residency credits. New filing requirements and owner ramifications of a PTE election also should be considered prior to electing in, as the state impact of an election for some owners could outweigh the benefit of the federal deduction received.
First, it is important to understand what the tax base is made up of and whether it is determined at the entity level or owner-by-owner level. Residency of the ownership group can dramatically affect the tax due, as some states will tax resident owners on their total share of income as opposed to their state-sourced income. Tax rates for PTE elections may vary even when compared to the owners' own personal state income tax rates, so consideration may extend to what owner requirements are necessary in terms of personal estimated payments where the credit may fall short of fulfilling the owner's total liability.
Second, the costs associated with the PTE election should be understood. It is likely the entity will need to adjust its filing approach to consider how an election will affect current nonresident withholding and composite obligations in addition to its new PTE filing requirements. This will have a similar effect for the owners, whose nonresident filing requirements may increase due to a PTE election. One of the largest concerns for owners relates to their residency credit for taxes paid to another state. If a PTE election and subsequent credit were excluded from the residency credit calculation, the loss of the home state credit could quickly outweigh the benefit of the federal deduction.
Step 2: Entity and owner considerations
Governing body questions concerning a PTE election: Once the PTE election opportunity is defined, the practitioner will need to determine which parties are responsible for executing on the state election. Generally, the entity's operating agreement should be reviewed to ensure the current language is sufficient to support a PTE election. Areas of concern include, but are not limited to, who has authority to make the election, the kind of owner consent required for making an election, and necessary steps to maintain a taxpayer's S corporation status, if applicable.
Entity concerns with implementation of a PTE election: In addition to new state tax filing requirements, entities will need to adjust cash flow planning for the upcoming expenses associated with PTE elections. Historically, entity distributions likely included state tax distributions for the benefit of the owners. Going forward, these funds will need to be held back to cover the entity's liability. The timing of estimated payments to the state will be crucial for both accrual-basis and cash-basis taxpayers to properly align deductions with credits received and avoid potential Sec. 461 issues.
Owner concerns with implementation of a PTE election: Conversations regarding PTE elections typically focus on the entity steps, but the implications to the owner group are just as important. Like the entity, owners similarly may experience changes in their filing process under a PTE election (especially in a nonresident situation). For a taxpayer to benefit from the PTE credit received, the taxpayer may be required to file personally with the state to receive the benefit. This will play a role in the owner's resident and nonresident filing requirements as they relate to estimated payments and extensions, as the credits received will have an impact on both filings. Also, PTE credits may play a role in the owner's resident state by affecting the residency credit and personal estimated tax payments due to the state.
Step 3: Following through with elections
Executing on PTE elections: With the research and discussions regarding PTE elections done, executing on the filings will be a timely last step. Significant attention to state-by-state details will be imperative in this area to ensure elections meet the necessary due dates and that there are no regrets over a missed election. The process for opting in to a state PTE election varies. In some states it is as simple as a check-the-box election. However, states require taxpayers to complete electronic filing procedures outside of practitioner software. Several states require timely estimated payments going forward to maintain valid elections. For example, in California a missed estimated payment on June 15 could invalidate a future-year election.
It is also worth noting the pace at which taxing authorities release guidance regarding elections. While legislative bodies are sometimes quick to push through legislation in response to resident demands, taxing authorities of the same state will not move at the same pace. Every practitioner who has dealt with PTE elections in states such as California, New York, Maryland, or Michigan can speak to the timeliness of information over the past couple of years. The time allotted by those states for filing accurate elections, forms, extensions, or payments on an enacted election in the recent past has been merely a matter of days or weeks, not months.
Future PTE election considerations: To conclude on the topic of PTE elections, a practitioner's job is not over with the filing of the return. As states race to get in front of the SALT workaround for their residents, amendments continue to filter in that expand or broaden the scope of those who can receive the benefit. As of this writing, nearly half of the states that have created a PTE election are undertaking various modifications to better suit intended beneficiaries — their residents. This could mean a PTE election that made sense in the previous year may no longer make sense going forward, and the irrevocable nature of elections could significantly shift the entity's burden. Practitioners will need to be on top of the moving pieces to make sure elections continue to make sense for their clients, all while keeping an eye on Washington to see what Congress has to say about a SALT cap repeal.
Anthony Bakale, CPA, is a tax partner with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at email@example.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.