March 2, 2022

If you are a partner in a partnership or a shareholder in an S Corporation, did your entity consider a pass-through entity tax (PTET) election as part of its 2021 year-end planning? Hopefully, you answered “yes.” Are you doing business in a state that does not allow for a PTET election, but you investigated the option? If you answered “no” or are unsure, keep reading.

While it may be too late for a 2021 deduction at this point, it’s not too late for a 2022 deduction related to those 2021 taxes – at least not yet. It is only a timing difference at this point, not a lost deduction. 

What’s a PTET Election?

Let’s pump the brakes for a minute. You are probably wondering, “What is a Pass-through Entity Tax (PTET) election?” Great Scott! To the DeLorean…

The Tax Cuts and Jobs Act (TCJA), enacted December 22, 2017 (effective for 2018), contained a tax provision limiting the state and local taxes (SALT) deduction to a $10,000 maximum for individual income taxpayers. Taxpayers most impacted are those living in states with high income tax rates, states with high real estate tax rates, with a double whammy for some taxpayers living in a state with both.

As constituent outrage grew, some state legislative bodies started drafting laws as a workaround to this provision. The result was the origination of the PTET election. As of November 2021, nearly 20 states have adopted a PTET election in some form as their workaround to the SALT cap limitation.

How’s a PTET Election Work?

Mechanically, the entity (rather than the individual partner/shareholder) pays the state income tax on behalf of its partners or shareholders. For federal purposes, the entity then receives a deduction for the state income taxes paid. The partners/shareholders receive a federal K-1 with that much less income reported on it (effectively deducting the state taxes from the owner’s income), therefore avoiding the individual $10,000 SALT limitation.

For state income tax purposes, states with a PTET election allow the entity to pass through either an income exclusion, tax credit, or some other form of withholding to the various partners/shareholders so that “credit” (for tax professionals, no pun intended) is given on the owner’s individual state tax return for the state taxes already paid.

What Are the Pros, Cons of Making the PTET Election?

Seems like a no-brainer in some cases. Why would you not make such an election if your state allows this? For example, suppose you own an operating business that only operates in your resident state. In that case, your state allows a PTET election, and all of the partners/shareholders are also residents of that state, you would probably make the election because very little additional analysis is needed.

However, all fact patterns are not that simple. More complex fact patterns require greater analysis.

For example, what if your business operates in multiple states? Do all of these states allow for a PTET election? Do the states in which your entity does business allow you to pick and choose who participates in the election, or are you stuck with all-or-nothing participation?

An entity doing business in multiple states may have to determine whether each state allows such an election. The mechanics and timing of making the election could differ in each state.

Do you have partners/shareholders who live in multiple states? The individual partner’s/shareholder’s resident states must be reviewed to determine if a credit is allowed for these taxes paid at the entity level under a PTET election.

Making the election in a state that allows a PTET election for a partner/shareholder who is a resident of a different state that does not give credit for these taxes already paid creates double taxation for that partner/shareholder. The partner/shareholder pays tax to the non-resident state at the entity level and then again to their resident state at the partner/shareholder level. Under this scenario, proper planning can address such inequities.

Key Takeaways

No two elections will be the same. You may have a simple fact pattern that requires little analysis, or you may have a complex fact pattern that requires a more in-depth analysis. There can be worthwhile tax benefits to making such an election, but there can be significant pitfalls if you blindly make the election without analysis.

If you are a partner in a partnership or shareholder in an S Corporation and your state and local taxes are being limited, we are here to help you navigate the complexities. Contact the F+H team today.

This information is general, not specific, and is only meant to give perspectives on matters discussed which may change without notice. It is not intended to be tax or financial advice. Information has been obtained from various sources believed to be reliable, but interpretations and accuracy are not assured. Please contact us for any questions you may have or to revisit your planning strategies.