Federal implications of passthrough entity tax elections

It has been two years since the IRS stated in Notice 2020-75 that it intended to issue regulations regarding the deductibility of certain state and local income tax payments imposed on passthrough entities (PTEs). However, as of this writing, no such regulations have been issued. Tax practitioners have gone through another tax season without substantive guidance answering critical questions regarding the interaction between PTE taxes and numerous federal tax provisions. In the absence of IRS regulations, tax practitioners are responsible for formulating positions that Notice 2020-75 did not provide.

Background

One of the most significant tax changes for individual taxpayers under the law known as the Tax Cuts and Jobs Act (TCJA),¹ enacted in December 2017, was the $10,000 limitation on the federal deduction for state and local taxes (SALT). Prior to the provision’s effective date, for tax years beginning before 2018, and after its scheduled sunset, for tax years beginning after 2025, individual taxpayers may receive a federal income tax deduction for all state and local real property taxes, personal property taxes, state or local taxes, and foreign taxes paid during the tax year, provided they itemize their deductions.

The Joint Committee on Taxation (JCT) estimated that the $10,000 federal limit on the SALT deduction would raise federal revenue by $77.4 billion for the 2019 tax year alone. The JCT also estimated that the $10,000 limit, coupled with the TCJA’s almost doubling of the standard deduction, would decrease the number of individual income taxpayers claiming itemized deductions from 46.5 million in 2017 to just over 18 million in 2018 — resulting in 88% of households filing tax returns using the increased standard deduction.² The federal government would receive a double benefit: additional revenue and simplified tax returns to review under audit.

However, some states were unsupportive of the limitation for fear it would decrease the ability to collect state and local income taxes. States with residents receiving the most value for the SALT deduction prior to the federal limitation included California, Connecticut, Maryland, New Jersey, and New York.³ These states were also the most active in trying to identify a workaround to allow their residents to receive a full federal SALT deduction.

New York, joined by Connecticut, Maryland, and New Jersey, filed suit against Treasury and the IRS in July 2018, alleging the federal limitation on SALT deductions violated the U.S. Constitution’s principles of federalism under the Tenth and Sixteenth amendments, coercing the states to abandon their preferred fiscal policies. On April 19, 2022, the Supreme Court denied a review of the ruling from the Second Circuit, which affirmed the 2019 federal district court decision that the federal SALT deduction limitation did not violate the Tenth Amendment.⁴ The Second Circuit noted that Congress surely understood that the limitation on the federal deductibility of SALT would affect some states more adversely than others, and nonetheless, like other federal tax laws, the tax law was within Congress’s permissible legislative purpose of influencing, while not compelling, tax policy.

In addition to the lawsuit, representatives from these states pushed for legislation to increase the SALT cap, with one such provision included in the House of Representatives’ Build Back Better Act⁵ passed by that chamber in November 2021. The proposal would have increased the SALT cap from $10,000 to $80,000; however, controversy soon arose that the proposed plan would benefit only high-income households. Objections to parts of the House bill by Democratic Sens. Joe Manchin, D-W.Va., Kyrsten Sinema, D-Ariz., and others were ultimately overcome with a substitute amendment that passed in the Senate and was then approved in the House — but without any provision relating to the SALT cap. That legislation was enacted in August 2022 as the Inflation Reduction Act.⁶

At the same time, several states explored workarounds that would allow residents to take a federal SALT deduction with no limitation. One such workaround allowed residents to donate to a local charitable organization and receive a state or local tax credit for the donation amount, anticipating that the federal government would allow the amount to be deemed a charitable itemized deduction. However, the IRS was quick to respond and generally denied this workaround through amending Regs. Sec. 1.170A-1(h)(3), proposed in August 2018⁷ and finalized in June 2019.⁸

With the IRS aggressively targeting attempts to create a SALT cap workaround and with no changes to the limitation coming from the courts or Congress, it seemed increasingly likely that taxpayers would have to wait until after 2025, when the SALT cap is set to expire, to receive a federal deduction related to state income taxes paid due to passthrough activity. However, one workaround seemed to gain legitimacy with the IRS and opened the door for PTEs to claim a SALT deduction.

In November 2020 the IRS released Notice 2020-75, which provided that proposed regulations would be forthcoming, while also clarifying that SALT imposed on and paid by a partnership or S corporation, referred to as specified income tax payments (SITPs), would be allowed as a deduction by the partnership or S corporation in computing its non–separately stated federal taxable income or loss for the tax year of payment. The notice allowed partners and S corporation shareholders to receive a federal deduction for SITPs, resulting in a benefit similar to what was provided to PTE owners prior to the TCJA’s $10,000 SALT limitation.

Under Notice 2020-75, an SITP was defined as any amount paid by a partnership or S corporation to a state, political subdivision of a state, or the District of Columbia to satisfy its liability for income taxes imposed by the domestic jurisdiction. The imposition of the state income tax can be a result of an election. In addition, PTE owners can receive a partial or full state deduction, exclusion, credit, or other tax benefit that is based on their share of the amount paid by the partnership or S corporation.

The IRS’s notice provided comfort for a variety of states to finalize legislation allowing state income taxes to be paid by the PTE, while providing a federal deduction for the amount paid. As of May 2022, 27 states and one locality had enacted legislation allowing passthrough entities to make SITPs and receive a federal income tax deduction.

While the notice provided an outline of what was required of states for their PTE taxes to qualify as a federal deduction, the legislation across the states is not unified. As many tax advisers have experienced, the ability of each state to create its own eligibility requirements and election procedures has made this workaround extremely complex. While everyone may be focusing on the state intricacies, a variety of unanswered questions remain regarding the impact of SITPs on the calculation of federal taxable income. Even though the notice was issued in November 2020, the proposed regulations are still not published, forcing tax advisers to navigate through the notice and develop positions based on the limited guidance provided.

Do SITPs have to be related to a trade or business to allow a federal deduction?

The language in the notice suggests that SITPs do not need to be related to a trade or business to give rise to a federal deduction. However, some states do require the PTE activities to be associated with a trade or business for the PTE to pay an SITP to the state.

The notice defines an SITP as any amount paid by a PTE to satisfy its liability for income taxes imposed by a domestic jurisdiction. Specifically, the notice defines an SITP to solely include “income taxes described in section 164(b)(2) for which a deduction by a partnership is not disallowed under section 703(a)(2)(B), and such income taxes for which a deduction by an S corporation is not disallowed under section 1363(b)(2).” Nothing within Sec. 164 limits the federal deduction for SALT to those attributable to a trade or business or an investment activity. Instead, it provides a federal deduction for individuals, investment activities, and businesses alike.

SITPs are deemed a Sec. 164 deduction and not a Sec. 212 expense, i.e., an expense associated with the production of income. The provisions of Sec. 212 were not intended in any way to disallow expenses that would otherwise be allowable but instead were enacted to allow for additional itemized deductions that wouldn’t otherwise be allowable as a trade or business expense.⁹This is clearly reflected when an individual receiving investment income would claim a federal SALT itemized deduction for state income taxes paid and not be subject to Sec. 212. Therefore, an expense does not automatically become nondeductible just because it is derived from a Sec. 212 activity.

As an SITP is deemed to qualify as a Sec. 164 deduction even if it is related to investment activities, it is not subject to miscellaneous itemized deduction limitations. The TCJA added Sec. 67(g), which provides that no miscellaneous itemized deductions, including expenses associated with the production of income, are allowed for any tax year beginning after Dec. 31, 2017, and before Jan. 1, 2026. However, Sec. 164 deductions are specifically excluded from miscellaneous itemized deductions under Sec. 67(b)(2).

Based on the notice identifying SITPs as Sec. 164 deductions, PTEs not involved in trade or business activities could be allowed a federal deduction for SITPs with no miscellaneous itemized deduction limitation. This could lead to practices where PTEs are created solely to benefit from a federal deduction related to the SITP.

Are accrued SITPs deductible?

Uncertainty surrounds whether an SITP must be paid by year end or merely accrued for a PTE to receive a federal deduction. Based on the ambiguous language in the notice, a position could be taken that, for accrual-based taxpayers, a tax liability either paid or accrued by year end can give rise to a federal tax deduction.

Section 3.02 of the notice defines an SITP to include any amount paid by an S corporation or partnership to a state to satisfy its liability for the state’s income taxes. Section 3.02 also discusses the deductibility of SITPs, allowing an S corporation or partnership a deduction when computing its taxable income for the tax year in which an SITP is made. However, the notice clarifies that the ability for an S corporation or partnership to deduct an SITP is “based on the statutory and administrative authorities described in section 2 of this notice.” Section 2 includes authorities upon which the notice is based, including Sec. 164(a), which allows a deduction for state and local income taxes that are paid or accrued.

Under the accrual method of accounting, a liability is incurred and generally is deducted for federal income tax purposes in the tax year in which:

■ All the events have occurred that establish the fact of the liability;

■ The amount of the liability can be determined with reasonable accuracy; and

■ Economic performance has occurred with respect to the liability.¹⁰

Economic performance for tax liabilities generally occurs at the time the tax is paid. However, an exception is provided for tax liabilities if:

■ Economic performance with respect to the liability occurs on or before the earlier of the date the taxpayer files a timely (including extensions) return for that tax year or Sept. 15 of the following tax year;

■ The liability is recurring in nature; and

■ The amount of the liability is not material or the accrual of the liability for that tax year results in a better matching of the liability with the income to which it relates.< ^{name=”fnref_11″ id=”fnref_11″ href=”#fn_11″>}

Therefore, an accrued SITP at the end of the tax year may be deductible in that year, provided the above tests are met. It cannot be overlooked that an SITP must be fixed to fall under the recurring-item exception. The timing of the election must be reviewed and can vary by state. Some states require the election to pay the SITP to be made in the year to which it relates, while other states require an election to be made only in the initial year, with the election binding for the future. Alternatively, some states require the election to be made on a timely filed state tax return.

For example, New York requires the 2022 election to have been made by Sept. 15, 2022,¹² while California does not deem a binding 2022 election to have been made until a timely return is filed, resulting in the election not being made until tax year 2023.¹³ If the election is not binding for the tax year it relates to, other facts and circumstances may allow for the liability to become fixed, including estimated tax payments or a board of directors’ resolution.

Lastly, a taxpayer is only permitted to adopt the recurring-item exception as part of its method of accounting in the first tax year in which the item was incurred.¹⁴

How should an SITP federal deduction be allocated among the owners?

After determining the amount of an SITP that is deductible at the federal level, the next requirement is to allocate the deduction among the PTE owners.

For partnerships, the deduction can be specially allocated among the partners, provided it meets the substantial-economic-effect rules. Substantial effect is met if the economic burden is allocated to the partner who receives the economic benefit. Economic effect is met if the operating agreement requires the maintenance of partner capital accounts in accordance with the principles of Regs. Sec. 1.704-1(b)(2)(iv), partner distributions upon liquidation are required to be made based on positive Sec. 704(b) capital accounts, and the partnership agreement contains a deficit restoration obligation or qualified income offset.¹⁵

While partnerships do allow for special allocations, S corporations are required to allocate items of expense on a per share, per day basis.¹⁶ This requirement forces S corporations to allocate the deduction associated with the SITP to S corporation shareholders pro rata, regardless of whether every shareholder receives a correlating state income tax credit or income exclusion related to the SITP. If disproportionate benefit is provided to select shareholders, the use of loan arrangements may be required to ensure the S corporation is not being depleted by SITPs made to the detriment of S corporation shareholders not receiving a state income tax credit or exclusion.

Is an SITP deductible in arriving at federal AGI?

The distinction between “above the line” and “below the line” deductions is particularly important when computing an individual taxpayer’s taxable income. The concept of adjusted gross income (AGI) separates deductions into one of two categories: (1) a deduction in arriving at AGI, or (2) an itemized deduction. Generally, a deduction in arriving at AGI (above the line) is more favorable than an itemized deduction (below the line) because of the various limitations that may apply to itemized deductions (e.g., the $10,000 cap on SALT deductions).

Generally, for SALT to be classified as an above-the-line deduction, it must be directly, and not remotely, connected with the conduct of a trade or business. For example, property taxes imposed on real property can be directly connected with the conduct of a trade or business. However, Temp. Regs. Sec. 1.62-1T(d) provides that taxes on net income are not deductible even though the taxpayer’s income is derived from the conduct of a trade or business. This concept is reflected when real estate investors are able to deduct real property taxes paid in relation to rental property as an above-the-line deduction, while the state income taxes paid in relation to the rental property must be reported as an itemized deduction.

The principle that SALT is not deductible in arriving at AGI is highlighted in a variety of cases, including Tanner, Strange, and Cutler.¹⁷

If state income taxes imposed on business income are not deducted above the line, how does the IRS conclude that such taxes imposed on a PTE can circumvent the regulations and case law? In Notice 2020-75, the IRS highlighted Rev. Rul. 58-25, which held that “a Cincinnati, Ohio tax imposed upon and paid by a partnership on the net profits of the partnership’s business conducted in Cincinnati was deductible in computing the taxable income or loss of the partnership.”

Although Rev. Rul. 58-25 reiterates the position that state taxes on net income are not deductible in arriving at an individual taxpayer’s AGI, in the case of a PTE, no provision was made for the computation of AGI. Therefore, as the ruling concludes, while net business income taxes imposed on an individual, either directly or through an unincorporated business, are not deductible in computing AGI, net business income taxes imposed on and paid by a PTE are deductible in computing the taxable income of the PTE, and the partners or members are not precluded from claiming the standard deduction. Therefore, SITPs are deductible in arriving at an individual’s AGI, so long as they are imposed upon and paid by a PTE.

If a state income tax refund is received, is it considered federal gross income in the following year?

One significant question that remains unanswered by the notice is whether refundable PTE tax credits are includible in income under the Sec. 111 tax-benefit rule. The tax-benefit rule is a federal tax concept partially codified under Sec. 111, which generally requires a taxpayer to include in gross income recovered amounts that the taxpayer deducted in a prior tax year to the extent those amounts reduced the taxpayer’s tax liability in the prior year.

Some practitioners have argued that Sec. 111 does not apply with respect to SITPs because the taxpayer claiming the deduction (the PTE) and the taxpayer receiving the refund (the partners or members) are not the same. However, in similar circumstances the courts have ruled otherwise.

In Maines,¹⁸ the Tax Court held that a New York qualified Empire zone enterprise (QEZE) real property tax credit for which a partnership paid and deducted property taxes and the individual partners received a refundable credit was includible in the partner’s federal gross income under the tax-benefit rule. The court held that it was of no consequence that the partnership paid and deducted the property taxes, while its partners received the refundable credit. As the Maines case demonstrates, Sec. 111 is not limited to cases where the same person receives both the deduction in the earlier year and the recovery in the later year.

A PTE owner who is allowed a federal deduction for an SITP and receives a state income tax refund in the same year may have to include the state income tax refund as federal gross income in the year of receipt. Several factors should be reviewed to make that determination, including whether the state benefit associated with the SITP is provided through a state income tax credit or income exclusion, as well as the state ordering rules for payments and credits.

While SITPs made by PTEs are deductible at the federal level, the state benefit that is passed to the S corporation shareholders or partners varies by state. Some states provide a state income tax credit that is allocated based on their share of what the PTE paid on the owner’s behalf, while other states allow the PTE owners to exclude the income related to the SITP when calculating their state taxable income.

A state income tax refund received from a state using an income exclusion will not be taxable at the federal level if a standard deduction was taken. If an itemized deduction was taken, the general rules regarding state income tax refunds will apply. Under the federal tax-benefit rule, a refund is not taxable to the extent it did not provide a federal benefit in a prior year.¹⁹ In an exclusion state, a refund may relate to composite payments, estimated income tax payments, or withholding tax payments. Therefore, provided none of these items were deducted when calculating federal taxable income, the federal tax-benefit rule would apply, and the state income tax refund could be excluded from federal taxable income.

Alternatively, a taxpayer receiving a state income tax refund resulting from an income tax credit created by an SITP could be required to include that refund in federal taxable income in the year of receipt. The state income tax refund may have provided a federal benefit, as the SITP gave rise to a federal deduction, and the taxpayer would no longer be allowed to exclude the refund under the tax-benefit rule.

The tax-benefit rule implications for an SITP creating a state income tax credit versus a state income exclusion can be demonstrated in the table “Illustration of Tax-Benefit Rule,” below.

While the exclusion state generates a state income tax refund of $12,000, it is related to estimated tax payments that did not provide a federal tax benefit, since a standard deduction was taken on the taxpayer’s federal return. Conversely, the $4,250 state income tax refund created by the credit state was entirely related to the credit associated with the SITP. As a result, it must be included in federal taxable income in the following year, since a federal benefit was derived in deducting the entire credit amount of $34,250 when calculating federal taxable income.

Many tax advisers have become accustomed to not reviewing the taxbenefit rule in relation to state income taxes since the passage of the TCJA, as more individual taxpayers are either taking the standard deduction or have enough state and local taxes, other than state income taxes, to maximize the $10,000 federal deduction when itemizing. The need to review state income tax refunds and determine whether they were generated by a credit associated with SITPs will cause additional administrative burdens and disclosures going forward.

However, a taxpayer’s receipt of a state income tax refund and a benefit from a credit associated with an SITP does not automatically cause the state income tax refund to be includible in federal taxable income. Careful review of the state ordering rules for credits and payments will be necessary.

For example, if a state requires a resident credit to be applied first, credits associated with SITPs second, and withholding taxes and estimated tax payments last, the state income tax refund would generally have to exceed the estimated or withholding tax payments before it is necessary to determine whether the state income tax refund would be includible in federal gross income.

However, some states require that credits associated with SITPs be applied last when ordering credits and payments. If a state income tax refund is received when the credit is applied last, it would be required to be included in federal taxable income to the extent of the federal deduction received. Because the federal deduction related to an SITP may not always match the associated credit, it is important for advisers to disclose the amount of the federal deduction received to properly calculate state income tax refund federal inclusions.

The impact of state ordering rules is highlighted in the table “Examples of State Ordering Rules,” below, and assumes a standard deduction was taken when computing federal taxable income.

In Example A, the state ordering rules require the credit be applied last, which results in the PTE owner’s including the state income tax refund in federal taxable income in the following year. However, in Example B the estimated and withholding tax payments were applied last, and a federal standard deduction was taken. As a result, none of the state income tax refund is required to be included in federal taxable income.

Further guidance needed

The AICPA released a comment letter in October 2021 requesting further guidance on several questions posed in this article, which have yet to be addressed by the IRS.²⁰ The limited guidance and discussions surrounding the federal impact of PTE tax payments and refunds is causing individual tax professionals to interpret the notice, leading to various understandings and applications, which could negatively affect taxpayers. For example, if the federal tax-benefit rule is overlooked, a taxpayer could benefit from a large federal tax deduction for SITPs and fail to include the corresponding refundable credit in federal taxable income in the following year.

The fact that the IRS has yet to release additional guidance or regulations leads some to fear that the government may reverse course altogether regarding its stance on PTE taxes, or when guidance is finally issued, it will cause a significant amount of adjustments to be identified, causing administrative burdens for tax practitioners. As a growing number of states have enacted PTE tax legislation in 2022, the need for additional federal guidance to ensure proper filings and client direction is prominent.

Footnotes

¹P.L. 115-97.

²Joint Committee on Taxation, Tables Related to the Federal Tax System as in Effect 2017 Through 2026 (JCX-32R-18) (April 24, 2018).

³Bellafiore, “Who Benefits From the State and Local Tax Deduction?,” Tax Foundation (Oct. 5, 2018).

⁴New York v. Yellen, No. 18-CV-6427 (S.D.N.Y. 9/30/19), aff’d, 15 F.4th 569 (2d Cir. 2021), cert. denied No. 21-966 (U.S. 4/18/22).

⁵H.R. 5376.

⁶Inflation Reduction Act, P.L. 117-169.

⁷REG-112176-18.

⁸T.D. 9864.

⁹Regs. Sec. 1.212-1(o).

¹⁰Regs. Sec. 1.446-1(c)(1)(ii)(A).

¹¹Regs. Sec. 1.461-5(b)(1).

¹²A one-time extension of the general requirement that the election may be made between Jan. 1 and March 15. See N.Y. Dept. of Taxation and Finance, Notice: Extended Deadline to Opt Into the New York State Pass-Through Entity Tax (PTET) for 2022 (Aug. 10, 2022), and N.Y. Tax Law §860(h).

¹³Cal. Rev. & Tax. Code §19900(d).

¹⁴Regs. Sec. 1.461-5(d)(1).

¹⁵Regs. Sec. 1.704-1(b)(2).

¹⁶Sec. 1377(a)(1).

¹⁷Tanner, 45 T.C. 145, 151 (1965); Strange, 270 F.3d 786 (9th Cir. 2001); and Cutler, T.C. Memo. 2015-73.

¹⁸Maines, 144 T.C. 123 (2015).

sup>19Sec. 111(a).

²⁰Letter from Jan Lewis, CPA, chair, AICPA Tax Executive Committee, to Holly Porter, associate chief counsel, Re: Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes (Oct. 26, 2021).

Contributors

Lynn Mucenski-Keck, CPA, MST, is national lead, Federal Tax Policy, at Withum in Rochester, N.Y., and Jeremias Ramos, CPA, is tax manager, National Tax Service Group, at Withum in New York City. For more information about this article, contact thetaxadviser@aicpa.org.