The Tax Cuts and Jobs Act (TCJA) of 2017 brought about several significant changes to the federal tax code. One notable change relates to the state and local tax deduction for individual taxpayers. Prior to 2018, an individual who itemized deductions on his or her personal income tax return could deduct 100 percent of state property taxes as well as either state income tax or general sales tax paid. However, the TCJA implemented a new rule (known as the “SALT limitation”) that limits an individual’s state and local tax deduction to $10,000 for tax years 2018 through 2025.[1] The SALT limitation resulted in larger tax bills not only for high-income taxpayers but also for middle-income residents of high-tax states. In response to the new rules, many states began implementing a new entity-level tax on pass-through entities (PTEs) as a workaround for the SALT limitation. On Nov. 9, 2020, the IRS released Notice 2020-75, in which the IRS indicates its acceptance of the workaround regimes. [2]
HOW IT WORKS
Although specific rules for the SALT limitation workaround vary by state, the general idea is consistent. The implementing state imposes an entity-level income tax on PTEs such as partnerships, S corporations and limited liability companies. The tax is assessed at a specified rate, which is equal to the highest individual rate in most states. Because the SALT limitation applies only to individuals, the PTE then deducts the entire amount of state taxes paid when calculating its federal taxable income, ultimately reducing each owner’s distributive share of income and avoiding the $10,000 limit at the individual level.
For state tax purposes, the implementing state adopts one of two regimes. Some states provide individual owners with a credit equal to the owners’ allocable share of state tax paid by the PTE — the credit regime. The individuals utilize the credit as a dollar-for-dollar offset against their personal state tax liability. Other states allow individual owners to exclude the PTE’s flow-through income on their individual state income tax return — the income exclusion regime. Both regimes ultimately ensure that the state income tax is paid at the entity level and does not flow through to the individual owners.
STATE-SPECIFIC GUIDELINES
To date, 17 states have enacted a PTE tax, and three states (Illinois,[3] Massachusetts[4] and North Carolina[5]) have pending legislation on the topic. In most of these states, the tax is elective, which allows entities to decide the best approach for their business and owners. However, the PTE tax is mandatory in Connecticut.
The table below provides a summary of each enacted state’s guidelines for the PTE tax. Please note that these summaries do not contain all the information, and further details regarding election eligibility requirements and application of the tax can be found in the referenced bills.
STATE |
EFFECTIVE DATE |
WHEN TO MAKE ELECTION |
RATE |
ADOPTED REGIME |
BILL |
AL |
Tax years beginning on or after 1/1/21 |
Election must be made on or before the 15th day of the third month following the close of the tax year for which the entity is electing to be taxed. |
5% |
Credit |
|
AZ |
Tax years beginning on or after 1/1/22 |
Election must be made on or before the due date or the extended due date of the entity’s return. |
4.5% |
Credit |
|
AR |
Tax years beginning on or after 1/1/22 |
Annual election must be made before the due date or the extended due date of the entity’s income tax return. |
5.9%; capital gains taxed at 2.95% |
Income exclusion |
|
CA |
Tax years beginning on or after 1/1/21 and before 1/1/26 |
|
9.3% |
Credit |
|
CO |
Tax years beginning on or after 1/1/22 |
Election must be made on an original, timely filed tax return. |
4.55% |
Income exclusion |
|
CT |
Tax years beginning on or after 1/1/18 |
N/A – PTE tax is mandatory, not elective. |
6.99% |
Credit |
|
GA |
Tax years beginning on or after 1/1/22 |
Annual election must be made on or before the due date or the extended due date of the entity’s income tax return. |
5.75% |
Income exclusion |
|
ID |
Tax years beginning on or after 1/1/21 |
Election must be made on a timely filed original return for the taxable year for which the entity is electing to be taxed. |
6.925% |
Credit |
|
LA |
Tax years beginning on or after 1/1/19 |
Election must be made on or before the 15th day of the fourth month after the close of the taxable year. |
Graduated 2% - 6% |
Income exclusion |
|
MD |
Tax years beginning after 12/31/19 |
Annual election must be made on a timely filed return. |
8% and 8.25% |
Credit |
|
MN |
Tax years beginning after 12/31/20 |
Annual election must be made by the due date or the extended due date of the entity’s return. |
9.85% |
Credit |
|
NJ |
Tax years beginning on or after 1/1/20 |
Annual election must be made by the 15th day of the third month following the close of the tax year. |
Graduated |
Credit |
|
NY |
Tax years beginning on or after 1/1/21 |
|
Graduated 6.85% - 10.9% |
Credit |
|
OK |
Tax years beginning on or after 1/1/19 |
Election must be made by the 15th day of the second month of the tax year for which the election is to be applied. |
5% (Individual) |
Income exclusion |
|
RI |
Tax years beginning on or after 1/1/19 |
Election must be made on or before the 15th day of the third month following the close of the taxable year. |
5.99% |
Credit |
|
SC |
Tax years after 2020 |
Annual election must be made on or before the due date or the extended due date of the entity’s tax return. |
3% |
Income exclusion |
|
WI |
Tax years beginning on or after 1/1/18 |
Annual election must be made on or before the due date or extended due date of the entity’s income tax return. |
7.9% |
Income exclusion |
CONCLUDING THOUGHTS
Before electing into the PTE tax in any of the states mentioned above, taxpayers should do their due diligence in understanding whether the election is best for them, including comparing the PTE to composite filings in applicable states. For example, entities with owners who do not itemize deductions may not benefit from the election. Entities with owners in lower tax brackets may end up paying more tax than required at the individual level. While the PTE tax may serve as a workaround for the SALT limitation, it may not be right for all businesses. Additionally, any taxpayer that does not meet the definition of a PTE may consider the pros and cons of restructuring to take advantage of these new entity-level taxes.
Keep an eye out, as the list of states with enacted PTE tax laws is continuously growing, and reach out to GHJ’s State and Local Tax Practice for any assistance.
[1] IRC §164(b)(6)
[2] IRS Notice 2020-75
[3] Illinois SB 2531
[4] Massachusetts Bill H4002
[5] North Carolina HB 889
