Potential Tax Savings for Pass-through Entity Owners
Sarah S. Kim, J.D., LL.M.
08.02.21 | SALT Chat
If you receive income from a pass-through entity (PTE) such as a partnership, an S Corporation, or a multi-member limited liability company, you could potentially lower your federal personal income tax liability through a PTE tax mechanism.
Generally, PTEs are not subject to an income tax at the entity level for federal or state income tax purposes. Instead, a PTE passes through its profits or losses to its owners, and the owners are taxed on their share of the PTE’s income or loss at the individual level. The 2017 Tax Cuts and Jobs Act, which capped individuals’ itemized deduction for state and local taxes (SALT) to $10,000, triggered a number of states to respond by adopting a PTE tax law to mitigate the adverse impact of such cap.
This is how a PTE works. If a PTE pays an entity-level tax on its income, the income tax paid is fully deductible as a business expense in computing PTE’s income for federal purposes. As a result, the owner’s share of the PTE income is reduced by his or her share of the PTE income tax paid, which is not subject to the $10,000 limitation. By contrast, if the PTE does not pay income tax at the entity level, then the owner is taxed on his or her share of PTE income at the individual level. Such tax would be subject to the $10,000 limitation.
As of today, there are 14 states that adopted PTE tax legislation, including New York, California, Massachusetts, and Alabama, all of which adopted the law effective January 1, 2021. Although they share the common purpose of being a workaround to the SALT deduction cap, the PTE tax rules vary among states. Generally, a PTE must make an election to pay tax at the entity level. One exception is Connecticut, which made the PTE tax mandatory. Most states require an annual election by a prescribed due date (e.g., the due date of the PTE’s business tax return). In a couple of states, however, the election is binding once made until terminated. In most states, the PTE tax election is binding for all partners but states such as California and Arizona allow an owner to opt out of the election. From the state income tax perspective, there is generally no tax impact because a resident owner is required to either exclude his or her share of income that was subject to PTE tax from taxable income or receive a credit for PTE tax paid if the PTE tax payment was added back to taxable income. Please check this article if you would like to find out more about the New York PTE tax. If you have any questions on the currently enacted PTE tax, I can be reached at 646.346.6467 | email@example.com or contact your Berdon advisor.
Sarah S. Kim is a Senior Tax Manager in Berdon LLP’s State and Local Tax Group with nearly 10 years of professional experience. Sarah advises Fortune 500 and middle market businesses across an array of industries. She has experience with various types of taxes, including corporate income and franchise tax, sales and use tax, personal income tax, unincorporated business tax, commercial rent tax, and real estate transfer tax.