Questions to consider before electing into a PTE tax

As many CPAs are aware, the $10,000 state and local tax deduction limitation (SALT cap) for individuals was included in the federal law known as the Tax Cuts and Jobs Act, P.L. 115-97, enacted at the end of 2017. As a possible workaround to the SALT cap, states started to enact passthrough entity (PTE) taxes, with Connecticut being the first state to do so as a mandatory tax, after which other states started enacting PTE taxes as an elective tax.

On Nov. 9, 2020, the IRS issued Notice 2020-75, which clarified that partnerships and S corporations may deduct their SALT payments at the entity level in computing their nonseparately stated taxable income or loss. The notice indicated that the IRS intended to propose regulations to this effect, but as of mid-2022 the Service has not issued any further guidance.

The owners of PTEs (partners, shareholders, and LLC owners) generally either may be allowed a state tax credit for their share of the PTE tax or may exclude their share of the PTE’s income in computing their state income tax.

Twenty-nine states have enacted a PTE tax, including most recently Missouri, which, as of this writing, is expected to sign one into law in the next few weeks. The 29 states are Alabama, Arkansas,* Arizona,* California, Colorado (retroactive to 2018), Connecticut (mandatory), Georgia,* Idaho, Illinois, Kansas,* Louisiana, Maryland, Massachusetts, Michigan, Minnesota, Mississippi,* Missouri,* New Jersey, New Mexico,* New York, North Carolina,* Ohio,* Oklahoma, Oregon,* Rhode Island, South Carolina, Utah,* Virginia, and Wisconsin. Additionally, New York City* has also adopted a PTE tax. Those marked with an asterisk are effective in 2022 or later.

Most states’ PTE taxes are effective beginning either in 2021 or 2022. Colorado recently revised its PTE tax to be retroactive to 2018. Pennsylvania (H.B. 1709) currently has a proposed PTE tax bill. Iowa (H.F. 2087) and Vermont (H. 527) also had proposed PTE tax bills in 2022, but their sessions have now ended without enacting them.

There are nine states with no owner-level personal income tax on PTE income: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.

The 10 remaining states with an owner-level personal income tax on PTE income that have not yet proposed or enacted PTE taxes are Delaware, Hawaii, Indiana, Kentucky, Maine, Montana, Nebraska, North Dakota, Vermont, and West Virginia.

Unfortunately, the states have taken differing approaches to their PTE taxes. The rules vary based on many factors, such as eligibility, election method, frequency (annual or one-time), tax base and rates, how and when to pay, filing forms, allowance of state credit for entity tax paid to another state, interaction with other state tax rules, etc. It is important for practitioners and taxpayers to read Notice 2020-75 and the relevant state’s PTE tax statute and any guidance and forms from the state tax agency prior to making any decisions.

The AICPA State and Local Tax Technical Resource Panel (SALT TRP) has been closely tracking PTE tax developments and, among other things, has created an interactive U.S. map that links to state-specific information. Members of the SALT TRP (and the AICPA SALT Deduction PTE Tax Task Force) also have pooled their knowledge to compile four lists of questions to consider in deciding whether to elect into a state PTE tax. These lists, set forth below, may be helpful for taxpayers and fellow practitioners to review before making decisions on electing into a PTE tax in any state.

Election issues

• Is the PTE tax statute elective or mandatory (only Connecticut’s is mandatory so far)?
• What percentage of ownership is required to make the election and what is the voting procedure (remember, voting requirements/procedures may vary from state to state)?
• Is the PTE required to make estimated state tax payments?
• When are estimated payments due?
• When is the election due? Has the election or filing been extended, especially when enacted in the first year the election is available?
• What is the effective date of the election? Is the effective date retroactive?
• Is the election binding for just the current year or for multiple years?
• Is the election required to be made annually?
• When can the election be revoked?
• What are the voting requirements/procedures and notification procedures for revocation?
• Is the PTE tax statute one that automatically sunsets if the SALT cap sunsets on Dec. 31, 2025, or does it expire on Dec. 31, 2025, regardless, or is it permanent?
• Which entities or types of owners are allowed to make the election?
• Can resident and nonresident owners make an election or consent to participate (if that is part of the state’s PTE tax regime)?
• What forms need to be filed?
• What is the entity withholding tax rate?
• What is the PTE tax rate?
• What is the highest individual tax rate (relates to composite filers)?
• Is there an exclusion of income (e.g., Wisconsin) or a flowthrough of income and credit for PTE tax paid (refundable or nonrefundable) (e.g., the majority of the states)?
• What are the benefits to members/partners and what are potential detriments?
• How is the PTE tax credit used in sequence with other credits for owners?
• Is there any alternative minimum tax issue from using a PTE tax credit?
• Double-check the operating or partnership agreement and consider:
  • Does the agreement even permit the PTE to elect to pay a PTE tax?
  • Are the voting requirements consistent with the PTE tax statute?
  • Do the allocation provisions properly allocate any PTE tax to each partner in a way that reflects the partner’s share of the economics?
  • Does the agreement allow cash distributions to nonelecting/nonconsenting/ineligible owners?
  • If there is a cash distribution provision, are distributable earnings reduced by the partner’s share of any PTE tax expense?
  • Are guaranteed payments reduced by the partner’s share of any PTE tax expense?

Federal issues

• How is excess PTE tax credit taxed?
• For federal income tax purposes, is the PTE tax deduction a Sec. 162 or a Sec. 212 deduction?
• Has Temp. Regs. Sec. 1.67-1T(c) been considered?
  • It provides for allocation of expenses related to both a trade or business activity and a production-of-income activity using a “reasonable basis.”
• Does the PTE tax reduce self-employment tax or net investment income tax?
• Will additional disclosures be necessary for all shareholders to properly treat the PTE tax deduction under the net investment income tax rules and passive activity rules?
• Can the entity apply a loss carry-forward from a prior year?
• Does the state election and payment sequencing create a “deposit” for federal tax purposes, such as where the payment was made in one year, but the entity cannot elect until the subsequent year when the election can be made?
• Will the IRS allow payment alone to be enough for a federal deduction (ignore deposit issues)?
• Does Notice 2020-75 allow a partnership to specially allocate the PTE tax to the consenting/eligible owners?
• How will the PTE tax deduction affect the Sec. 199A deduction? Is there a reduction in the Sec. 199A qualified business income deduction?
• What is the timing of payment when deducting for federal tax purposes (some partners will have tax effects depending on the year the distribution is made)?
• Which year does the entity take the federal deduction? The owners should consider the tax law on “deposits” and methods of accounting.
• How does the entity report any refund of the PTE tax?
• Must a refund be separately reported to the owners in order to determine the tax treatment?
• Are there any complications for S corporations related to:
  • Shareholder agreements?
  • Per share, per day allocation of income/expense?
  • Disproportionate distributions?
  • One-class-of-stock issue?

State issues

• Does the PTE tax regime exclude the PTE’s income from the owners’ returns?
• What income and deductions will be included in the state taxable income base for the PTE tax?
  • For example, will charitable contributions reduce the base?
  • Will a sale of the entity structured for tax as an asset sale increase the base?
  • Will a sale of the entity structured for tax as a stock sale be includible in the base?
• Does the PTE tax include the distributive share of otherwise exempt owners?
• Is there nonbusiness income that will be sourced to a state if the election is made?
• Does the PTE tax payment deducted for federal tax purposes create a nondeductible item for state taxes that reduces the shareholder basis before losses and deductions?
• Does the PTE tax regime provide a full or partial credit to owners for taxes paid?
• Are there limits on the shareholders’ ability to use the credit on their state returns?
• Will other states in which the PTE is doing business allow a credit for the PTE tax at the owner level?
• Is nonresident partner or shareholder withholding still required when the PTE election is made?
• Can the PTE election and payment of PTE tax at the entity level satisfy a nonresident member’s state filing requirement (i.e., such that a separate filing by the member is not required)?
• Can a passthrough entity still elect to file a composite return if a PTE election is made? If yes, how is the PTE credit applied/claimed?
• Can estimated composite, withholding, and/or individual estimated payments be transferred to the PTE’s account to cover the PTE tax?

Taxpayer and tax practitioner issues

• What are the compliance costs (including CPA fees)?
• How much risk does the election create for the entity or owners, assuming that the IRS issues no more guidance?
• Does an operating agreement need to be reviewed by legal counsel and/or amended in order to optimize, or otherwise account for, an efficient election?
• Are the entity and owners “eligible” as defined under the state’s PTE tax statute?
• Who determines if qualified taxpayers (owners) consented?
• Who is charged with monitoring new state department of revenue guidance or changes in the laws of the states in which the PTE tax election has been made, or might be made, if the law or conditions changed?
• How will the election be made and documented, and what documentation is needed to prove an owner consented or not to the election?
• Is the election or vote made anonymously with respect to other partners or not? Note that the partnership and its managers (and advisers) ultimately need to know who elected.
• What are the mechanical issues involving the state PTE tax return preparation? For example, if the return must be filed through the state’s website, the tax practitioner may be required to obtain a power of attorney or a specific type of account authorization in order to be able to prepare and release returns for clients. Note that even if that is possible, the practitioner may not want to do that or may need contractual language. For example, if the practitioner’s firm is also the auditor for the taxpayer, perhaps the practitioner may need to be more careful about what information tax preparers would have if they entered into a client account. 
• What is the likelihood of interest in the SALT cap workaround, assuming the entity and at least one owner are “qualified”?
• If the SALT cap is raised by Congress, does that change the willingness of qualified taxpayers (owners) to consent to (or continue) the election?
• Do owners have sufficient tax they individually owe on their share of PTE net income so that they are above the SALT cap?
• In which states should an entity with income taxed in multiple states pay the optional state PTE tax?
• How and when should amended returns and audits be handled? Like the comprehensive partnership audit rules, does the partnership/operating agreement specify who handles these?
• Does the partnership/operating agreement require a distribution to all partners?
• If the PTE tax deduction is reported on Schedule K-1 in “Other Deductions,” rather than in nonseparately stated ordinary business income, will an additional disclosure be needed, since the return will not comply with the notice?
• What will the effect be on distributions to defective grantor trusts that were expected to fund installment sale payments?
• (For tax practitioners only) Conflict of interest and malpractice risks in advising owners and entities, such as:
  • How to explain unknowns to a client.
  • How to advise entities and owners who may have conflicting interests and when the law is not 100% clear.
  • How to handle a situation where not all owners consent or are eligible.
  • How to deal with issues when not all owners consent or are not all eligible to get a state tax credit, as this situation likely causes a violation of an S corporation’s one-class-of-stock requirement and, for a partnership, it might violate the partnership agreement and cause other tax and legal issues for the entity and owners.

Resources

The SALT TRP is continuing to monitor the situation and has developed several tools for state CPA societies and AICPA members, including:

• AICPA map of states with adopted or proposed PTE-level taxes;
• AICPA SALT Roadmap — State and Local Tax Guide;
• AICPA issue paper on state PTElevel tax implementation issues (Oct. 4, 2018);
• AICPA summary of state PTE-level tax implementation issues (Oct. 4, 2018); and
• AICPA comments to the IRS on Notice 2020-75 and forthcoming proposed regulations (Oct. 26, 2021).

See also these resources:

• Bell-Jacobs, et al., “Where Individual, Corporate, and Passthrough Entity Taxation Meet,” 52 The Tax Adviser 392 (June 2021); and
• Multistate Tax Commission project on state taxation of partnerships.