The State and Local Tax (SALT) deduction allows taxpayers to deduct money paid to state and local governments from their federal income taxes. In 2017, the Tax Cuts and Jobs Act (TCJA) established a $10,000 cap on SALT tax deductions in an attempt to limit deductions taken by high-income taxpayers on their personal tax returns, thus increasing the amount of tax they would pay. The states that took the biggest hit when SALT deductions were capped were California, New York, and New Jersey due to extremely high real estate and state income taxes in those states. Real estate deductions were reduced significantly by the $10,000 limit.
Luckily, high income taxpayers can utilize pass through entities to circumnavigate the SALT deduction cap and maximize their federal tax deduction. With this tax strategy, individuals can pay their state income taxes through a pass-through entity instead of through personal income. The result is that the paid state income taxes can then be fully deducted from the taxpayer’s federal taxes, even if it exceeds the $10,000 SALT deduction limit. Here’s how it works and how to understand if this will work for you.
What is a pass through entity?
A pass-through entity, also referred to as a flow-through entity, is essentially a business entity that does not pay any federal taxes. It passes the income, losses, gains, and/or credits to its shareholders/owners where those items of activity are taxed at the individual’s tax rates.
The most common types of pass-through entities are:
- Partnerships – General Partnership (GP), Limited Partnership (LP), and Limited Liability Partnership (LLP)
- Limited Liability Companies (LLC) that are taxed as S-Corporations or Partnerships
The most common types of pass-through entities we work with are involved in construction, manufacturing, real estate, consulting, legal services, and technology, especially startups.
The most common exception to qualifying as a pass-through entity is when you have a disregarded entity. The most common example of a disregarded entity is an LLC that is 100% owned by one person or jointly owned by spouses in a community property state. A disregarded entity reports income directly on the individual income tax return, and does not have a separate filing obligation. A disregarded entity may qualify to be treated as an S-Corporation if the S-Election is filed and accepted by the IRS.
How does a pass through entity elective tax work?
The pass-through entity tax (PTET) election works by allowing a business entity to choose to pay the income tax related to a shareholder’s/owner’s apportioned activity. The business can then deduct the taxes it pays as an expense and the shareholder/owner claims a pass-through entity tax (PTET) credit on their individual tax return.
Here’s an abbreviated version of the process:
- Business entity confirms that it qualifies as a pass-through entity
- Business entity elects to pay a shareholder/owner’s income taxes
- Business entity deducts the taxes paid as an expense
- Shareholder/owner claims a pass-through entity tax credit on their individual tax return
Why elect to pay the pass-through entity tax?
We recommend our clients use the PTET when they expect to have taxable pass-through income for a specific tax year. If their pass-through business has a net taxable loss for a specific tax year, there will not be a PTET credit and therefore no benefit to using it. We also recommend the PTET method for any clients who are hitting the $10,000 SALT limit on their personal tax return.
|Here’s an example:
We have a client who is an S-Corporation with two business owners. Each owner files their personal taxes in the state of Georgia. If we filed the S-Corporation taxes without the PTET, the two business owners combined would pay $66,000 to Georgia in state taxes for 2022. Only the first $10K each would be deductible on their personal returns (maybe even less). However, because we elected to do the PTET at the entity level, the S-Corporation is now paying the $66,000 in taxes directly to Georgia on behalf of the shareholders. The additional deduction of $66,000 will generate a federal tax savings of close to $20,000. Ultimately, the PTET will be an annual tax savings, just shifting where the tax is paid from.
How does the PTE tax vary by state?
Making an election for PTET varies from state to state and continues to evolve as tax laws change and efficiencies are discovered through trial and error. The only state to require a PTE tax is Connecticut. Some states, like Colorado, require you to make a formal election before you file a business tax return, while other states, like Virginia, allow you to make the election at the time the business tax return is filed. Some states, like California, also require quarterly payments.
If you have a pass-through entity that does business in multiple states, you first have to determine the amount of taxable or distributive income allocated or apportioned to each state. Once that amount has been determined, you can file to claim a PTET credit based on each state’s share of business activity and each state’s tax laws.
At the end of the day, the deduction will vary based on the state’s income tax rate (or lack thereof). New York and California are the two states with the highest individual tax rates while Arizona sits at the bottom of the list.
If you’re hitting the $10,000 SALT deduction limit, it’s worth exploring how the pass-through entity tax election can help. No matter the state(s) you live and operate businesses in, we can help. Our clients across the U.S. trust us to maximize their federal returns through experienced tax strategy. Schedule a call with us to learn more.