PTETs: Orchestrating ASC 740 compliance

Editor: Mo Bell-Jacobs, J.D.

One of the more challenging issues that partnerships, S corporations, and other passthrough entities (PTEs) must consider in the complex world of state and local taxes (SALT) is the passthrough entity tax (PTET) and the related accounting for and reporting of income taxes resulting from an entity’s activity under FASB Accounting Standards Codification (ASC) Topic 740, Income Taxes.

PTETs enable PTEs in specific states to elect taxation at the entity level for state income tax purposes. Generally, these elections may (1) allow an entity’s partners or shareholders to claim credits on their individual state income tax returns for the amount of their distributive share of the PTET paid by the partnership or S corporation and (2) relieve partners or shareholders from the requirement to report their distributive share of income on their personal state income tax returns.

Although a state’s PTET can significantly affect a company’s overall effective tax rate, it is important to recognize that the laws vary from one state to the other. (See “Passthrough Entity Tax Regimes By State,” with tax rates and other pertinent information.) This lack of uniformity can create a changing and uncertain environment in which afftected companies must carefully assess their tax positions separately in each state and determine the appropriate recognition and measurement under FASB ASC Subtopic 740-10 to stand up to IRS scrutiny. Significant judgment may be required for newly developing tax regulations that differ by state and potentially apply to entities previously not subject to Topic 740.

Background

The law known as the Tax Cuts and Jobs Act (TCJA)1 limited the state and local tax deductions that individual taxpayers are permitted to claim on their federal tax returns. For tax years 2018 through 2025, the law introduced a $10,000 limit on individuals’ state and local tax deductions,2 significantly reducing tax savings opportunities for many residents in high-tax states where property taxes alone often exceed the $10,000 cap.

To help minimize the tax impact of the TCJA on the vast majority of U.S. businesses structured as PTEs, several states began establishing their own income tax regimes that enabled these entities to pay taxes to the state and shift the full availability of SALT deductions away from owners and shareholders directly to the partnerships, S corporations, and other PTEs they operate. The shareholders and partners in these entities may also receive corresponding tax credits that pass through to their individual tax returns.

Two years later, the IRS issued Notice 2020-75, voicing its support of these SALT cap workarounds and clarifying that state and local income taxes paid by a partnership or S corporation are allowed as a deduction in “computing its non-separately stated taxable income or loss for the taxable year of payment.” Therefore, the IRS said in an accompanying news release, such tax payments “are not subject to the state and local tax deduction limitation for partners and shareholders who itemize deductions.”3 This guidance opened the floodgates, allowing more states to enact PTET laws. Today, 36 states and New York City have passed PTET legislation, effective retroactively to 2021 or earlier.

Accounting requirements

How domestic and foreign companies may account for PTET and other taxes under GAAP is covered by Topic 740, which requires reporting companies to issue meticulous memorandums analyzing and documenting their positions for taxes based on income. The standard defines taxable income as “[t]he excess of taxable revenues over tax deductible expenses and exemptions for the year as defined by the government taxing authority.”4

Among the line items in a company’s balance sheet related to income are current tax payables or receivables, deferred tax assets, deferred tax liabilities, valuation allowance, current and deferred tax expenses or benefits, and total income tax expense or benefit. Excluded from this list are (1) franchise or capital taxes for which there is no additional tax based on income and (2) withholding taxes for the benefit of dividend recipients.

Many questions can arise in practice as to whether PTET regimes under Topic 740 require the accounting of income tax at the entity level (i.e., attributable to the entity) or if such expenses should be treated as assets and liabilities of the entity’s owners and partners. Like most provisions of tax law, the answer depends on the language contained in each state’s specific law. However, as a rule, entity attribution can occur when:

• State laws and regulations relieve owners of the requirement to file tax returns and/or the entity is not permitted to claim tax payments against its owners;
• The income tax liability is not jointly held by the PTE’s owners;
• The income tax paid by the entity is excluded from the owners’ income tax returns; and
• The attributes of the PTE owners do not determine the tax base.

When reporting this information on a Topic 740 memorandum, taxpayers must include the amount of taxes payable or refundable in the current year and the impact of the PTET on their entities’ deferred tax assets and liabilities. Additional items to document in the memo may entail answering any of these questions:

• Who ultimately bears the economic risk of the associated taxes paid (the PTE or its owners/investors)?
• Are PTET payments that are submitted to the state claimed on the entity’s tax return or those of the owners/shareholders?
• Is the state’s PTET regime mandatory or optional?
• Whom does the state require to make the PTET election (the entity or the owner) and when?
• Is the election revocable?
• Are the entity’s owners jointly and severally liable for the tax liability?
• What is management’s intent with regard to claiming the PTET?
• Does the jurisdiction’s PTET permit loss or credit carryforwards realized at the entity level?
• What happens when the timing of financial statements differs from the required date of making a timely filed PTET election?
• Does the PTET permit loss or credit carryforwards realized at the entity level?
• Is revocation available for elected PTET regimes?

Connecticut

The first state to adopt a PTET regime in 2018 was Connecticut, which created a requirement for partnerships, S corporations, and limited liability companies (LLCs) treated as partnerships or S corporations to pay a 6.99% tax on the PTE’s Connecticut taxable income and, in turn, receive an offsetting refundable credit against individual income and corporate taxes.

Beginning in 2024, however, the Connecticut PTET became optional, making it possible for entities to annually elect into the regime via written notice to the state’s Department of Revenue Services no later than the state’s extended filing deadline for the entity’s return. Payment is due by the 15th day of the third month following the end of the entity’s tax year.

Entities opting in to Connecticut’s PTET regime in 2024 also face changes to the tax base calculation. More specifically, they must maintain the 6.99% tax rate and use an alternative base calculation that includes the sum of the modified Connecticut-source income and the resident portion of unsourced income, excluding income passed through corporate members.

Connecticut is not alone in its approach to directly taxing PTEs. Other states that impose taxes at the entity level are Oklahoma, which requires PTEs to withhold tax for partners if they do not make a PTET election, and Louisiana, which does not recognize S corporations. Tax directors operating in these and other jurisdictions must navigate the specific tax regulations of each state and incorporate these nuances into their Topic 740 compliance efforts.

New York

Unlike Connecticut, which provides a tax credit to the entity paying the PTET, New York allows a dollar-for-dollar tax credit for PTET paid to flow through to the entity’s partners, members, and shareholders (including estates and trusts) while also allowing the entity to fully deduct the PTET paid as a business expense. The PTET in New York can range from 6.85% to 10.9%, plus an additional 3.876% for partnerships in which at least one partner is a resident of New York City.

New York also differs from Connecticut in that the annual election to opt in to the PTET regime must be made by March 15 of a tax year. This is often before the entity completes its financial statements and knows whether the PTET election is beneficial.

New Jersey passthrough business alternative income tax

New Jersey has a unique optional business alternative income tax (NJ BAIT) for PTEs that enables LLCs, partnerships, and S corporations to elect to pay and deduct on their federal returns a tax on New Jersey–source income. In turn, the entity’s members, partners, or shareholders receive a refundable tax credit on the amount of tax paid by the PTE on their share of distributive proceeds. Calculating the correct New Jersey–source income and determining the appropriate tax liability can be a complex endeavor involving various factors.

Entities seeking to opt in to the NJ BAIT must make an annual election by filing the appropriate state forms electronically on or before March 15 of the tax year. Compliance with the filing and reporting requirements is crucial to avoid penalties and ensure the entity remains in good standing with the state.

It is also important to note that state residents can remit NJ BAIT returns to pay tax on their worldwide income, thereby excluding the NJ BAIT from the PTE’s Topic 740 memorandum.

Other AICPA resources on PTET

The AICPA State and Local Tax Technical Resource Panel has created many PTET resources, including a map with effective dates, states’ PTET provisions and guidance, taxpayer and practitioner election considerations, articles, podcasts, AICPA comment letters, and more.

Also, the AICPA’s Center for Plain English Accounting (CPEA) continues to help its members with the accounting and auditing implications related to SALT cap workarounds.

Harmonizing across states

While the PTET allows residents in most U.S. states to circumvent the $10,000 cap on state and local tax deductions, it is important to remember that the laws can differ substantially from one jurisdiction to the next, creating a potentially difficult reporting environment for entities operating across multiple states. For example, the required timing and methods for making special elections into the PTET and paying the related taxes can vary widely. Three fundamental concerns are:

1. An accurate calculation and recognition of deferred tax assets and liabilities, including the impact of state-specific PTETs — this involves understanding the unique tax base and rate applicable at the entity level.
2. A Topic 740 memorandum that clearly and precisely contains the state-specific PTETs, their treatment, and their impact on deferred tax positions.
3. Topic 740 financial statement disclosure requirements for which tax directors must detail statespecific PTETs’ material impact on the reporting entity.

For companies navigating the intricate landscape of state tax implications for PTEs, the inclusion of states like Connecticut with direct PTETs adds a distinctive note to the symphony. By carefully considering the implications of such taxes on Topic 740 compliance, tax directors can ensure accurate financial reporting and compliance in this evolving and diverse tax environment. In this complex orchestration, knowledge and precision become the keys to successfully harmonizing state tax compliance and financial reporting for PTEs.

Contributors

Karen A. Lake, CPA, is a director of tax services, and Luke Lucas, CPA, is an associate director of tax services, both with Berkowitz Pollack Brant Advisors CPAs in Fort Lauderdale, Fla., or working remotely. Mo Bell-Jacobs, J.D., is senior manager of State and Local Tax, Washington National Tax, at RSM US LLP in the Washington, D.C., area. Bell- Jacobs is chair, and Lake is a member, of the AICPA State and Local Taxation Technical Resource Panel. For more information about this column, contact thetaxadviser@aicpa.org.