Are Pass-Through Entity Taxes Worth The Hype?

It has now been five years since Connecticut became the first state to enact a Pass-Through Entity Tax (PTET) in response to the federal SALT deduction cap. Since that time, 36 states and one locality (New York City) have enacted a PTET, each a little different from the other. In addition, even in the short time that these PTETs have been in existence, some states have made significant changes to their PTETs. For example, New York has expanded the PTET tax base for S corporations with resident shareholders; Connecticut recently switched to a fully elective PTET (it previously had a mandatory PTET with an alternative elective base); and California expanded the definition of eligible entities to partnerships with non-individual owners.

But with five years of PTET now under our belts, and the vast majority of states with a personal income tax having enacted a PTET, it’s a good time to ask the question: Are the PTETs living up to their hype? States jumped aboard the PTET wagon in response to the Tax Cuts and Jobs Act (TCJA), which limited individuals to a $10,000 deduction for state and local taxes on their federal personal income tax returns, a limitation that sunsets after December 31, 2025 absent further action by Congress. In response to that limitation, a number of states quickly responded with a variety of different “workarounds.” The most seemingly successful—or at least popular–of those responses was to transfer the incidence of state tax for pass-through entities (partnerships, LLCs taxed as partnerships, and Subchapter S corporations) from the individual owners to the entities themselves. Since the TCJA did not limit the SALT deduction for business entities, the owners would still get the benefit of the deduction and take a credit at the state level for the taxes paid by the entity. Simple, right?

As with everything in the state tax world, nothing is simple. But it’s helpful to lay out a few things we have learned, positive and negative, in the last five years. Let’s the upsides and downsides of PTE.

Upsides of PTE

• IRS seems to be on board (so far)

  Notice 2020-75 alleviated some initial concerns that the IRS would challenge what everyone was calling a SALT deduction “workaround.” Since that Notice, the IRS has not issued any further guidance that would indicate a different approach.

• PTETs seem to do what they advertised

  There’s certainly a spectrum of how much benefit a PTET owner will obtain, but to the extent they promised a way to allow more of a federal deduction than permitted under the TCJA by shifting the incidence of the state tax, they provide a mechanism to do so.

• Taxpayers and their advisors are more familiar with PTETs and their potential benefits
  

  Whereas a few years ago, a PTET might have been one of those acronyms only familiar to the nerdiest of state tax nerds, they have become a regular part of the conversation between pass-through entity owners and their tax advisors.

• States are generally respecting other states’ PTETs and giving individual resident owners credits for those taxes.
  

  Initially, there was a lot of concern that individual residents of a state would not be able to claim a credit for a PTET paid by the entity in another state, particularly when the first PTETs were enacted in 2018 and 2019. But almost all states have clarified through legislation or guidance that their residents will be able to take a credit for those taxes paid to other jurisdictions.

• Most PTETs require annual elections
  

  If it turns out to create more problems than benefits in one year, the entity is not bound by the election in the following year!

Of course, there have also been some bumps in the road:

Downsides to PTE

• There is still no consensus on PTET deductions for investment partnerships
  

  The IRS has not issued any guidance following Notice 2020-75 and it remains unclear if, and how, an investment partnership can deduct a PTET expense on its federal return.

• Every PTET is different
  

  The areas of difference among PTETs are almost as great (or possibly greater!) than their similarities. How the election is made; when the election is made; whether tax is paid on only sourced income; whether owners get a credit or an exclusion; who adds back what into the tax base; and whether combined returns are allowed are just some of the many nuances that differentiate each state’s PTET. My heart goes out to tax preparers who have been flooded with these questions over the last few years, on top of all the other questions arising from the many significant federal and state tax law changes in recent years.

• State PTET guidance is limited
  

  These are new taxes so guidance, whether written or verbal, from state taxing authorities is hard to come by. So, it can be difficult to get clear answers on the thornier questions, like the treatment of carryforward losses, changes in accounting methods, etc. Even states like New York that tend to publish more guidance, have sometimes provided contradictory information, or changed guidance on certain issues, like addback modifications and amending returns. Again, my heart goes out to those tax preparers!

• There is no simple formula to determine whether it makes sense to elect into a PTET
  

  There are too many differences among PTETs, and very unique factors to consider in making the decision to elect or not in various states. It is always recommended to put pen to paper and figure out whether there will be a significant federal tax benefit in making an election that is worth the potential costs (additional tax prep, audit risk, etc.). But other issues, such as partnership allocations or individual state tax credits can make the analysis much more complicated.

Are the State PTETs a Solution to the SALT Deduction Cap?

Like many other things, it depends. They certainly offer a route to replace a valuable deduction mostly lost (at least for now) with the TCJA. But pass-through owners and their tax advisors are wise to look closely at the particularities of the PTET before electing in, especially if there are multiple state PTET elections at issue. Their value is not automatic and in some cases, will create more headaches and potential costs than they are worth.

If you’re interested in learning more detail about PTE taxes, I will be presenting a 2-hour webinar for University of Illinois Tax School on Tue., Aug. 8 on Multistate PTE Taxes & Resident Credit 

By Liz Pascal, J.D., Ph.D.
Hodgson Russ LLP, Partner

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