In the past few weeks, we have seen a continuation of states enact entity-level taxes on pass-through entities (PTEs). These elective PTE taxes allow for business owners to sidestep the limitation on the amount of state and local tax (“SALT”) that individuals may deduct for federal income tax.
On July 9, 2021, legislation was enacted where a pass-through entity, such as a partnership or S corporation, would be allowed to elect an entity-level tax. For tax years beginning January 1, 2022, a qualifying entity that makes such election would pay a 4.5% tax on all taxable income of a resident partner and a portion of taxable income derived from sources within Arizona.
The election is required to be made by the due date of the return; or if on extension, by the extended due date. The legislation also allows for individual, estate, or trust partners to withdraw from the election of the entity-level tax. Partners included in the entity-level tax in turn will receive a personal state income tax credit equal to the portion of the tax paid on their share of passthrough income.
On July 16, 2021, California Governor Gavin Newsom has signed a budget bill that creates an elective pass-through entity tax. For taxable years beginning on or after January 1, 2021, and before January 1, 2026, a qualified entity doing business in California can make an annual, irrevocable election to pay a pass-through entity tax similar to the New York PTET, that was passed several months ago. The tax is computed at the rate of 9.3% for the taxable year for which the election is made.
Entities eligible to make the California PTE election include entities taxed as partnerships (except publicly traded partnerships) and S Corporations. This elective tax is in addition to, and not in place of, any other tax required to be paid under California’s personal income tax or corporation tax laws. As such, owners of pass-through entities making the election claim a credit for their share of the pass-through entity’s PTE tax on their respective returns. If this results in an overpayment, excess credit may be carried forward for five (5) years.
There may be some uncertainty if general partnerships would qualify to elect the PTE tax, as only an S Corporation, Limited Liability Company, Limited Liability Partnership, or Limited Partnership is listed in the Bill Analysis. Also, diverging from other states that have passed PTE taxes, the legislation does not explicitly provide a resident credit to California residents for comparable PTE taxes elected in other states.
On July 1, 2021, the governor signed into law a PTE workaround. For tax years after December 31, 2020, a qualifying entity can irrevocably elect to file and pay a pass-through entity tax. A valid election must be made by owners holding more than 50% of the entity, which such election would be imposed on all qualifying owners. A qualifying entity includes a partnership, limited liability company or a S corporation. This does not include entities that has partnership, limited liability company (unless it is a a disregarded entity) or a corporation as a partner or shareholder. The election must be made by the date the return is due or the extended due date.
The tax is equal to the state taxable income as sourced to Minnesota, and taxed based on the highest marginal individual income tax rate at 9.85%. Once paid, additional withholding tax for nonresident partners or shareholders are not required in the same year. Taxpayers would be allowed to claim a credit equal to the amount of PTE tax paid on their personal tax return.
In addition, residents can claim a resident credit for income taxes paid by partnerships to another state based on the partner’s share of tax paid by the partnership.
On July 16, 2021, Massachusetts Governor Charlie Baker signed the Fiscal Year 2022 (FY22) budget into law, which included a provision for pass-through entities to make an election for a PTE tax. However, at the time of this writing, Governor Baker sent the PTE provision of the law back to the legislature for some revisions. It is still unclear if and when this SALT PTE will be implemented.
As we have been advising businesses with previously enacted PTE taxes, a number of different factors will play a role in considering making elections into entity-level taxes. It is vital all the various considerations are modeled out. A key consideration may be owners state residency, but there may be potential structuring strategies in order to maximize the federal benefit to owners.