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What to Know About State Pass-Through Entity Tax (PTET)

Key Points

  1. Pass-through entity tax election has been introduced by a vast number of states in response to TCJA in the past few years.
  2. Simple case studies illustrate how PTE tax elections can significantly impact federal tax liabilities and offer insights into potential savings or losses based on owners’ decisions.
  3. Understanding nuances, considering state-specific rules, meeting deadlines, and consulting professionals are important factors in making the right decision.

Table of Contents

  1. What is a State Pass-Through Entity tax?
  2. How Does It Work?
    • Case Study 1
    • Case Study 2
  3. States Participating in Pass-Through Entity Tax
  4. Helpful Questionnaire
  5. Conclusion

Pass-through entity taxation is a crucial aspect of the financial landscape for businesses structured as partnerships, S corporations, or limited liability companies (LLCs). In this brief guide, we’ll explore the intricacies of pass-through entity tax, provide practical case studies, outline the states participating in this tax structure, discuss relevant deadlines, and present a questionnaire to help business owners assess their understanding and compliance.

1. What is a State Pass-Through Entity tax?

State pass-through entity (PTE) taxes refer to a mechanism by which states tax the income of certain pass-through entities at the entity level rather than at the individual level. Pass-through entities, such as partnerships, S corporations, and limited liability companies (LLCs), do not pay federal income tax at the entity level. Instead, their income “passes through” to the individual owners, who report and pay taxes on their share of the income on their personal tax returns.

The federal Tax Cuts and Jobs Act (TCJA) of 2017 imposed limitations on the state and local tax (SALT) deduction for individual taxpayers. As a result, state-level PTE taxes can provide a way for business owners to potentially mitigate the impact of the SALT deduction limitation and maintain a competitive environment for businesses operating as pass-through entities.

2. How Does It Work?

IRS Notice 2020-75 served as the IRS approval to PTE taxes as a workaround against the $10,000 cap, allowing the entities to deduct these state taxes at the business level. The procedures for electing and calculating PTE taxes vary distinctly from state to state: number of payments, due dates, the compliance method, and so on. Effective PTE tax planning requires a comprehensive understanding of the specific regulations in the state of residence and all the states where a pass-through entity may operate.

Typically, the PTE election procedure has 4 general elements at the entity level with up to 4 modifications at the individual level:

Taxation at the Entity Level
  1. State Income Tax Election: The pass-through entity opts to pay state income tax at the entity level, usually through an annual election.
  2. Payment of State-Level Income Tax: The entity pays the state income tax obligation, either through estimated tax payments or with the tax return.
  3. Federal Modification for State Tax Deduction Reported on Schedule K: The federal ordinary income of the entity reported on Page 3, Schedule K, Line 1, includes the state tax deduction in the year the state income tax is paid. While each state’s rules drive the income and tax reported, there is no federal limit to the amount of PTE tax deducted and claimed by each state.
  4. Pro-Rata State Tax Credit Allocation: A pro-rata state tax credit share is passed to its owners on their state Schedule K-1.
Taxation at the Owner Level
  1. Federal Reduced Income for State Tax Deduction on 1040: The owner’s share of the PTE tax paid by the company reduces the individual taxpayer’s adjusted gross income (AGI), line 11 of 2023 Form 1040. The AGI is used to determine the amount of income tax and certain credits for which you might be eligible. Moreover, AGI is the first component of your modified AGI used to determine eligibility for deductions, credits, and retirement plans.
  2. Reduced Self-Employment Tax for a General Partner on 1040: The general partner’s income from the partnership is subject to self-employment tax, which is reported on Schedule 2 of Form 1040.
  3. Reduced Income For Calculating Qualified Business Income Deduction, or Section 199A deduction: The results may vary depending on the threshold, but should your income come higher than the Section 199A taxable income threshold, reducing taxable income may open up the Section 199A deduction that was not available to you before.
  4. State Tax Credit: While each state form is different, the schedule of credits shows the amount paid by the entity. This amount decreases the individual owner’s state income tax liability on the state income tax return. You should note that such credits might be refundable or nonrefundable, depending on the state.

Case 1:

Facts:
  • Bill is a single shareholder in an S-Corporation named Funny Business Inc.
  • In 2024, Funny Business Inc. reports an ordinary income of $150,000.
  • Bill resides and operates a business in the state of Alabama.
  • Alabama’s PTE tax rate is 5%.
  • Funny Business Inc. makes the PTE tax election and pays tax on Bill’s behalf
  • Bill is married to Linda, and they file their 1040 return married filing jointly.
  • Bill and Linda’s only sources of income are a W-2 and K-1 from Funny Business Inc.
  • They don’t itemize deductions on their federal tax return
  • Bill and Linda’s combined taxable income falls into the 24% federal tax bracket.
Issue:

How does the PTE tax election help Bill to reduce his federal taxable income and pay less tax to the IRS?

Calculations:
  • Funny Business Inc. pays PTE tax of $7,500 [$120,000 x 5%] during tax year 2024
  • By making a PTE election, Funny Business Inc.’s federal ordinary income drops from $150,000 to $142,500.
Results:
  • Reduced Bill’s taxable income on Form 1040 has an effect on his tax liability and, consequently, Section 199A deduction.
  • After reviewing annually adjusted thresholds tables, Bill’s taxable income falls below the Section 199A threshold in 2024. Funny Business’s PTE tax deduction reduces his Section 199A qualified business income and Section 199A deduction.
  • The oversimplified federal tax savings estimate is $1,440 = $1,800 – $360
    • Tax reduction from PTE tax election $1,800 [$7,500 x 24%]
    • Section 199A deduction reduction $360 [$7,500 x 24% x 20%]

Case 2:

Facts:
  • Bill is a single shareholder in an S-Corporation named Funny Business Inc.
  • In 2024, Funny Business Inc. reports an ordinary income of $150,000.
  • Bill resides and operates a business in the state of Alabama.
  • Alabama’s PTE tax rate is 5%.
  • Funny Business Inc. makes the PTE tax election and pays tax on Bill’s behalf
  • Bill is married to Linda, and they file their 1040 return married filing jointly.
  • Bill and Linda’s only sources of income are a W-2 and K-1 from Funny Business Inc.
  • They don’t itemize deductions on their federal tax return
  • Bill and Linda’s combined taxable income falls into the 24% federal tax bracket.
  • NEW Funny Business Inc. does not make the PTE tax election
Issue:

How does passing on making the PTE tax election affect Bill’s federal taxable income and pay less tax to the IRS?

Calculations:
  • Funny Business Inc.’s ordinary income is the same for federal and state purposes: $150,000.
Results:
  • AL state tax on income from Funny Business Inc., paid by Bill personally, is $7,500
  • Bill and Linda lost the deduction because their itemized deductions were below the standard amount.
  • Federal tax savings are $0
  • Should Funny Business have made a PTE election, Bill and Linda would have saved $1,440, as calculated in Case Study 1.

3. States Participating in Pass-Through Entity Tax

While the federal government recognizes and accommodates PTE taxation, individual states have their own tax codes and regulations. According to AICPA, as of December 19, 2023, 36 states (& 1 locality) have adopted specific provisions related to PTE taxation. The list of states and the rates with some form of PTE tax election includes:

NoStateEffective YearRate
1Alabama20215.00%
2Arizona20222.50%
3Arkansas20224.70%
4California20219.30%
5Colorado2018 (retroactive)4.50%
6Connecticut2018 (mandatory 2018-2023, elective starting 2024)6.99%
7Georgia20225.75%
8Hawaii202311.00%
9Idaho20215.80%
10Illinois20214.95%
11Indiana2022 (retroactive)3.23%
12Iowa2022 (retroactive)6.00%
13Kansas20225.70%
14Kentucky2022 (retroactive)5.00%
15Louisiana20191.85% to 4.25%
16Maryland20208.25%
17Massachusetts20215.00%
18Michigan20214.05%
19Minnesota20219.85%
20Mississippi20224.00% to 5.00%
21Missouri20224.95%
22Montana20235.75%
23Nebraska2018 (retroactive)6.84%
24New Jersey20205.68% to 10.90%
25New Mexico20225.90%
26New York20216.85% to 10.90%
27New York City20223.88%
28North Carolina20224.99%
29Ohio20225.00%
30Oklahoma20194.00%
31Oregon20229.00% to 9.90%
32Rhode Island20195.99%
33South Carolina20213.00%
34Utah20224.95%
35Virginia20215.75%
36West Virginia20226.50%
37Wisconsin20187.90%

Please note that tax laws are subject to change from year to year, and it is crucial to verify the most recent information for accurate compliance.

4. Deadlines for Pass-Through Entity Estimated Tax Payments and Elections

While federal tax deadlines are generally consistent, state deadlines can vary. Business owners should be aware of both federal and state deadlines for pass-through entity tax filings.

5. Helpful Questionnaire

The following questionnaire has been prepared to assist business owners and tax professionals in understanding their obligations and opportunities regarding pass-through entity taxation.

  1. Is your business structured as a pass-through entity (e.g., partnership, S corporation, LLC)?
    • Yes
    • No
  2. Does your state have specific provisions for pass-through entity taxation?
    • Yes
    • No
  3. Does your company expect to make a profit this year?
    • Yes
    • No
  4. Is your business operating in multiple states, and if so, have you considered the state-specific rules for pass-through entity taxation?
    • Yes
    • No
  5. Are you aware of the state pass-through entity tax rate?
    • Yes
    • No
  6. Are you aware of the state deadlines for pass-through entity tax filings?
    • Yes
    • No
  7. Have you consulted with a tax professional to ensure compliance with pass-through entity tax regulations?
    • Yes
    • No

5. Conclusion

Pass-through entity taxation offers businesses a flexible and efficient tax structure. Understanding its nuances, considering state-specific provisions, meeting filing deadlines, and consulting with tax professionals are crucial steps for businesses aiming to navigate this complex landscape successfully. As tax laws are subject to updates, it is recommended to stay informed and seek professional advice for the most accurate guidance tailored to specific business needs.


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