PTE deduction: Timing issues for accrual-method taxpayers

Editor: Mo Bell-Jacobs, J.D.

It has been over two years since the IRS issued Notice 2020-75, which effectively blesses an entity-level workaround to the individual $10,000 state and local tax deduction limitation imposed through 2025 and enacted as part of the law known as the Tax Cuts and Jobs Act, P.L. 115-97.

As background, Notice 2020-75 announces the intent of Treasury and the IRS to issue proposed regulations on the deductibility by a passthrough entity (PTE) of a “specified income tax payment,” which is defined as “any amount paid by a partnership or an S corporation” to a state, a political subdivision of a state, or the District of Columbia to satisfy its liability for income taxes they impose on the partnership or the S corporation. To date, no such guidance has been published, and the priority of this guidance is unclear after the passage of the Inflation Reduction Act of 2022, P.L. 117-169, and the competing need for guidance in other areas of the tax law.

With the lack of expanded guidance in this area, taxpayers and practitioners face uncertainty regarding the timing of the deduction provided for in the notice. Specifically, for passthrough entities on the accrual method, the issue arises of whether the deduction must be taken in the year the tax is paid or whether it is possible to take the deduction in the preceding year.

Timing rules

The notice states that if a partnership or an S corporation makes a specified income tax payment during a tax year, it is allowed a deduction for the payment “in computing its taxable income for the taxable year in which the payment is made.” This language implies that a deduction is only allowed in the year of payment. However, the notice fails to address whether certain special rules apply relating to accrual-basis taxpayers and the timing of their state income tax deductions.

For a cash-basis taxpayer, the notice’s language appears in line with the general rules under Regs. Sec. 1.461-1. A taxpayer utilizing the cash receipts and disbursements method of accounting is generally allowed a deduction for an item in the tax year in which it is paid.

For an accrual-basis taxpayer, the notice is also in line with the general rules under Regs. Sec. 1.461-1 but does not address the applicability of certain special rules that may allow for the acceleration of a deduction for state income tax payments. A taxpayer utilizing an accrual method is generally allowed a deduction for a liability when all events occur to establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance occurs with respect to the liability. For state income taxes, Regs. Sec. 1.461-4(g)(6) provides that economic performance occurs as the tax is paid to the governmental authority that imposed the tax.

Thus, accrual-method taxpayers may generally deduct state income taxes in the year paid, similar to a cash-basis taxpayer. However, a special rule exists under Regs. Sec. 1.461-5 for accrual-basis taxpayers regarding the timing of a deduction for certain recurring items, such as state income taxes. This is known as the recurring-item exception.

The recurring-item exception

Under this special method of accounting, an accrual-basis taxpayer may deduct a qualified item in the tax year preceding the actual year of payment, provided that at the end of that tax year:

• All events have occurred that establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy;
• Payment occurs on or before 8½ months after the end of the tax year;
• The liability is recurring in nature; and
• Either the amount of the liability is not material or the accrual of the liability for that tax year results in better matching of the liability with the income to which it relates.

For a state income tax liability, the regulations provide that the matching requirement of the recurring-item exception is deemed satisfied. Thus, under the recurring-item exception, an accrual-basis taxpayer generally may accelerate the deduction for state income taxes to the year prior to payment, notwithstanding the general economic performance rules under Sec. 461.

While not certain, the notice does not appear to change any general rules or regulations under Sec. 461, so it stands to reason that, provided the requirements of the recurring-item exception are met, an accrual-basis taxpayer should be able to utilize this exception to deduct a specified income tax payment in the tax year accrued, even if payment is made in the subsequent year.

There are some important considerations to keep in mind if a taxpayer wishes to use the recurring-item exception for these specified income tax payments. First, the recurring-item exception is a method of accounting. Passthrough entity taxpayers should review their prior income tax return filings and determine if a method of accounting has been established for the deduction of state income taxes. If not, taxpayers can adopt the recurring-item exception the first time they incur the item. If a “deduct when paid” method has been established for income taxes, taxpayers may be able to make an automatic accounting method change to begin applying the recurringitem exception.

Second, the fixed and determinable prongs of the all-events test must be met before the recurring-item exception can be utilized. Each imposing jurisdiction’s elections should be reviewed in detail to determine whether the liability is fixed and determinable at year end.

Editor Notes

Mo Bell-Jacobs, J.D., is a senior manager with RSM US LLP. Contributors are members of or associated with RSM US LLP. For additional information about this item, contact John Charin, J.D., LL.M. (John.Charin@rsmus.com); Ryan Corcoran, CPA (Ryan.Corcoran@rsmus.com); and Kate Abdoo, J.D., LL.M. (Kate.Abdoo@rsmus.com), Washington, D.C.