Pass-Through Entity Taxes & Elective Workarounds

23.1 Pass-Through Entity Taxes & Elective Workarounds

States’ reactions to the federal State and Local Tax (SALT) deduction cap have spurred a range of innovative strategies aimed at restoring a greater portion of the SALT deduction to individuals. One of the most prominent developments has been the introduction of pass-through entity (PTE) taxes. By imposing a tax at the entity level (partnership, S corporation, or in some states an LLC taxed as a partnership), states enable owners of those entities to reduce their personal taxable income—thereby mitigating the effect of the $10,000 SALT deduction cap (or $5,000 for married filing separately). This section explores the mechanics of PTE taxes, highlights variations among the states, and guides CPA candidates on the potential exam-day challenges and planning perspectives related to these elective workarounds.

Overview of the SALT Deduction Cap

Since the passage of the Tax Cuts and Jobs Act (TCJA) of 2017, taxpayers who itemize their deductions have been limited to a maximum of $10,000 in state and local taxes paid. This includes state income taxes, general sales taxes, and property taxes. While the purpose of the SALT deduction cap was to raise federal revenue and limit the perceived subsidization of higher-tax states, it created widespread concern in states with above-average income and property taxes. Legislators in these states responded with various workarounds to preserve the tax benefit for their constituents, the most notable of which are PTE-level taxes.

Pass-Through Entity (PTE) Taxes: Conceptual Framework

A pass-through entity is typically not subject to income tax at the entity level, with its income flowing through to individual owners or shareholders who pay tax on their distributive or pro rata shares. This flow-through tax treatment was traditionally considered advantageous because it avoided double taxation. However, in a high-SALT environment, paying the state tax at the entity level may create a federal deduction on the entity’s tax return. This effectively shifts the deduction from the individual (where the SALT deduction cap applies) to the business entity (where there is generally no $10,000 cap), thereby reducing the owner’s overall taxable income.

How It Works

1. The entity elects to pay state tax on pass-through income.
2. The entity’s owners then claim a corresponding credit or an income exclusion on their individual returns, depending on state rules.
3. Because the entity pays the tax, it typically deducts the tax for federal income tax purposes as an ordinary and necessary business expense.
4. This allows the tax to bypass the SALT cap on the personal return, preserving a more substantial federal deduction.

Below is a simplified mermaid diagram illustrating this concept:

    flowchart LR
	    A[Individual Owners] --> B[Pass-Through Entity (PTE)]
	    B --> C{State PTE Tax}
	    C --> D[Deduction at Entity Level]
	    D --> E[Reduced Taxable Income for Owners]

Though elegantly structured, the PTE tax approach varies from state to state, and not every state has adopted it.

State Approaches: Key Variations and Examples

States that have enacted elective pass-through entity taxes typically follow one of two models:

• Model 1: Imposed PTE Tax + Owner Credit
• Model 2: Taxable Income Exclusion or Modification

These states generally share the same intent: provide a workaround for residents to pay their state taxes through an entity and thus access a larger federal deduction. The primary differences lie in the details: the election process, filing requirements, rates, credit mechanics, compliance timelines, and interplay with existing entity-level taxes.

Model 1: Imposed PTE Tax + Owner Credit

Under this model, the state imposes a dedicated tax on the pass-through entity’s net income. Owners then claim a credit for their share of income taxes paid at the PTE level. Basic steps include:

1. Entity makes an annual election to file and pay the PTE tax.
2. Each owner’s share of the PTE tax is calculated based on ownership percentages or partnership allocations.
3. The owner claims a credit on their state individual income tax return for the portion of the PTE tax attributable to them.

Examples: • California: Eligible entities can elect the Pass-Through Entity Elective Tax. Owners receive a credit on their individual returns for their share of the tax.
• Connecticut: Mandates a PTE tax for most pass-through entities with offsetting credits.

Model 2: Taxable Income Exclusion or Modification

In other states, owners might exclude from their taxable income any amounts that were already taxed at the entity level. This ensures that the same income is not being taxed twice. One key difference is that some states treat PTE-level taxes differently for nonresidents versus residents; additional complexities arise when considering multiple states or partial-year residency.

Examples: • New Jersey: Offers the Business Alternative Income Tax (BAIT), which provides an exclusion and subsequent credits.
• New York: The PTET (Pass-Through Entity Tax) lets S corporations and partnerships elect to pay entity-level taxes with a corresponding deduction, thereby lowering owners’ federal taxable income.

Elective Processes and Compliance Requirements

Most states require an explicit election each year to participate in the PTE tax regime. This election is typically irrevocable for that tax period, though some states allow automatic renewal or opt-in by default once the entity enrolls in a program.

Key compliance steps typically include:

• Filing an election form or schedule with the state by a specified date (often the same date as the original tax return due date).
• Making estimated payments if required, which can be more complex if owners are spread across multiple states.
• Detailed reporting on the K-1 or equivalent schedule to indicate each owner’s share of the entity-level tax.
• Claiming any credits or income exclusions on personal state returns.

It is critical for entities to consult updated state instructions, as the rules can change, especially if new legislation modifies deadlines, rates, or credit carryforward provisions.

Federal Tax Considerations

While the approach is designed to relieve the burden of the SALT cap, certain ambiguities might arise:

• Deductibility Under IRC §164: There is often discussion concerning whether the IRS will accept these entity-level payments as fully deductible business expenses. So far, the IRS has indicated that properly structured PTE taxes qualify as deductible “taxes on the entity,” but CPAs should stay alert to additional guidance or court cases down the road.
• Impact on Basis Calculations: Owners of pass-through entities must carefully track their basis. The PTE taxes could affect distributions, basis, and the net amount recognized upon sale or dissolution.
• Potential AMT Interactions: Although the Alternative Minimum Tax (AMT) is significantly curtailed for individuals post-TCJA, high-income taxpayers still need to monitor how entity-level taxes affect their AMT calculations.
• Consistency in Multi-State Contexts: Entities with nexus in multiple states face added complexity if only one (or some) states offer a PTE tax election. Owners may still have to pay SALT in non-electing states at the individual level.

Practical Examples and Case Studies

To clarify important planning considerations, let’s examine sample scenarios that might appear on the CPA exam or in real client situations.

Example 1: Single-State S Corporation Elects PTE Tax

• ABC S Corp is based solely in California, with two owners who are both California residents.
• ABC elects into California’s PTE tax for 2023, which imposes a 9.3% rate (hypothetical rate for illustration).
• ABC pays $100,000 in PTE taxes. This $100,000 is fully deductible in calculating the S corporation’s ordinary business income on the federal return.
• Each owner receives a credit on their California individual return for their respective share of the $100,000.
• On their federal returns, no SALT cap is triggered for that $100,000 because the payment happens at the entity level.

Example 2: Multi-State Partnership with Mixed Residency

• XYZ Partnership operates in both New York and New Jersey. Some partners are residents of these two states, and others reside elsewhere.
• The partnership elects into New York’s PTET for all income allocated to the New York-sourced portion, and similarly elects into New Jersey’s BAIT for the partnership income sourced to New Jersey.
• Nonresident partners of both states see a credit or income exclusion on their respective nonresident filings, while residents typically get full or partial credits on their resident returns.
• Minimal SALT is paid at the individual level, reducing the effect of the SALT deduction cap. However, this multi-state environment requires complex tracking of each partner’s in-state and out-of-state allocations, along with potential differences in PTE tax rates.

Example 3: Partnership with Non-Electing States

• QRS Partnership has operations in multiple states, but only a few states offer a PTE election.
• QRS elects into PTE taxes in States A and B but not in States C and D (non-electing).
• Partners with income from States A and B generally receive credits or deductions that mitigate the SALT cap.
• Partners with income from States C and D remain subject to the SALT deduction cap at the individual level.
• For some partners, the SALT deduction cap may still apply to taxes paid in States C and D, underscoring the partial nature of these workarounds.

Best Practices, Risks, and Potential Pitfalls

• Subchapter S Requirements: If the entity is an S corporation, inadvertently violating shareholder eligibility rules or miscalculating distributions could lead to termination of S status.
• Timing of Elections and Payments: Missing election deadlines or estimated payment due dates can nullify the intended tax benefits for that tax year.
• Rate Comparisons: Each entity should compare effective PTE tax rates with individual tax rates because some states set PTE tax rates differently than the top marginal individual rates.
• Owner Communication: Executing a PTE-level tax strategy often requires unanimous or majority consent, depending on state law and entity agreements. If an owner does not benefit from the approach (e.g., a nonresident at a lower tax bracket), disputes might arise.
• State-Specific Reciprocity: Some states provide reciprocal tax agreements. Passing income through an entity-level tax can distort typical reciprocity benefits if not accounted for properly.

Planning Considerations for CPA Candidates

1. Know the difference between mandatory versus elective PTE taxes. Connecticut, for instance, imposes a mandatory entity-level tax on pass-throughs, whereas many other states offer an elective framework.
2. Differentiate between models: tax as an entity-level income tax or an excise tax. This language can influence federal tax deductibility.
3. Watch the credit mechanics: Some states offer refundable credits, others nonrefundable. Some allow carryforwards, some do not.
4. Keep in mind how these rules interact with federal basis regulations, partnership or S corporation distribution orders, and special allocations.
5. Understand how multiple states simultaneously applying PTE taxes can create or prevent overlapping credits.

For exam success in the Tax Compliance and Planning (TCP) section, focus on the nuances of each approach and how to evaluate the best structure for hypothetical clients. The exam may gauge your knowledge on electing entity-level taxes under varying scenarios, basis adjustments, entity-level compliance, and potential multi-state complexities.

Diagram: Comparing SALT Limitation Approaches

The following mermaid diagram compares traditional individual SALT payment versus the PTE approach:

    flowchart TB
	    A((Traditional SALT Payment at Individual Level)) --> B[Subject to $10k Cap]
	    B --> C[Limited Deduction on Schedule A]
	    A2((Entity-Level PTE Tax Payment)) --> D[Deduction at Entity Level (Full Deductibility)]
	    D --> E[No SALT Cap on Individual Return]

In this simplified comparison, the top path (traditional SALT payment) subjects the taxpayer to the $10k cap, while the bottom path (PTE tax) often circumvents the cap by shifting the tax deduction from the individual to the entity.

Moving Forward with SALT Workarounds

Although the SALT deduction cap may be subject to legislative changes in the future, states have shown considerable creativity in designing PTE-level taxes and other SALT cap workarounds. CPAs must stay attentive to each state’s unique rules, as these approaches play a significant role in comprehensive tax planning for passthrough entities and their owners.

For the exam candidate, a command of these topics can be integral to success in the Tax Compliance and Planning (TCP) section, as pass-through entity taxation is increasingly tested. Mastering PTE-level tax computations, basis implications, K-1 reporting of credits, and multi-state regulatory details can differentiate a borderline candidate from a top scorer.

Quiz: Pass-Through Entity Tax Workarounds & SALT Deduction Insights

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