A growing list of states have enacted laws allowing pass-through entities to elect into pass-through entity tax regimes as a workaround to the $10,000 federal cap on state and local tax deductions for individual taxpayers. Under these regimes, the PTE pays its owners’ state taxes and takes a deduction equal to the tax paid, while the owners receive a credit or exclusion of state income equal to their state tax liability. Because the SALT cap doesn’t apply to taxes assessed at the entity level, the PTE can typically take a federal deduction for its entire PTET payment.
The IRS provided guidance on the federal tax treatment of PTET payments in November 2020. However, questions remain regarding the tax implications of PTET elections, particularly in M&A transactions. The effect a PTET election has on a transaction depends on many factors, including the applicable state PTET law, timing of the PTET deduction, type of PTE entity involved, and whether assets or ownership interests are being sold or purchased.
Impact of State Law
The details of the state law authorizing the tax are critical to understanding the potential impact of a PTET election on a transaction. State law governs when and how a PTET election is made, which may impact the year in which a taxpayer can deduct a PTET payment. The answer to the timing question may, in turn, influence who ultimately receives the PTET benefit.
State law may also limit the types of PTEs that can make a PTET election, and eligibility issues may affect the PTE’s value at sale. Taxpayers considering a transaction involving a PTE should review the applicable state law to determine potential tax benefits and whether the PTET regime requirements have been met or can be met in the future.
Timing of a PTET Deduction
Improper planning may result in a significant loss of tax savings, so careful consideration should be given to when the PTET liability is deductible, since that could occur either before or after the closing date.
The tax year when a PTET liability becomes deductible for federal tax purposes can depend on several factors, such as whether the PTE is a cash-basis or an accrual-basis taxpayer and what steps the PTE has taken to elect into the PTET regime by year-end. A PTET liability is generally not deductible by an accrual-basis PTE until the tax year in which the PTET liability is considered fixed and economic performance has occurred, or an exception applies.
Similarly, the deduction for cash-basis taxpayers may be impacted by state law requirements and whether the PTE is legally liable for the PTET payment under state law.
Satisfying the requirements for a PTET liability to be deductible for federal tax purposes can be complicated, so taxpayers should evaluate these requirements carefully to ensure the PTET liability is deductible in the tax year the parties intend.
Pass-Through Entity Types
Typically, S corporation shareholders prefer to sell stock instead of assets to help ensure that transaction proceeds are taxed at preferential capital gain rates. However, the situation is more nuanced when considering the sale of a PTET-eligible S corporation.
If the S corporation sells its assets and elects into the PTET regime, the state tax assessed at the entity level wouldn’t be subject to the SALT cap. The taxable income that passes through to the S corporation’s shareholders would be reduced by the PTET deductions at the PTE level. If the shareholders sold stock instead, the state tax would be assessed at the shareholder level and any federal tax deduction would be subject to the SALT cap.
An asset sale has additional consequences, such as potentially changing the tax character of gain recognized in the sale. That said, the availability of PTET deductions inside the corporation should be considered since the deductions may result in a lower tax burden to the sellers. This would reduce the cost to buyers that are reimbursing the sellers for their costs of accommodating an asset sale.
Similarly, partners in PTET-eligible partnerships that wish to maximize SALT deductions may prefer to sell assets instead of partnership units. The SALT cap generally doesn’t apply to an eligible federal tax deduction at the partnership level. Thus, a PTET deduction in conjunction with an asset sale at the partnership level may reduce the taxable income allocated to the partners, reducing the total tax cost.
If the owners sold equity in the partnership, tax would be assessed at the level of the owners and likely be subject to the SALT cap if they were individuals. The federal tax character of a partnership interest sale is impacted by the assets of the entity, so there are fewer differences between equity interest and asset sales.
Partners don’t always benefit equally from PTET deductions depending on the state law, purchase agreement, and partnership agreement. Many partnership agreements don’t differentiate between types of deductions, so taxpayers should review agreements to ensure they will receive the expected PTET benefits.
Partners that receive guaranteed payments are especially vulnerable to losing the PTET benefit since the deduction may be allocated to other partners. However, they may receive an economic benefit since the burden of paying the state taxes on the guaranteed payments may be transferred from the partner to the partnership if the PTE election is made. Partnerships could reduce guaranteed payments to manage this.
When considering a transaction involving a PTET-eligible entity, taxpayers should ask:
- What are state law requirements for making a PTET election, and can those requirements be met?
- When does PTET liability become deductible for federal income tax purposes, and is it before or after the deal closes?
- Is the PTE involved in the transaction an S corporation or a partnership?
- Is the transaction a sale of ownership interest or a sale of assets?
Taxpayers considering a transaction involving a PTET-eligible entity should contact their tax adviser to discuss the circumstances of the transaction and potential tax benefits.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Mike Monaghan leads the National Tax Office for Plante Moran. He specializes in handling the tax aspects of transactions and frequently plans the purchase, sale, formation, and restructuring of businesses.
Tony Israels is a state and local tax principal for Plante Moran. He leads the firm’s state and local tax due diligence group and helps clients navigate SALT liabilities and filing responsibilities as part of their acquisitions and sales.
Jennifer Keegan is a National Tax Office manager for Plante Moran. She specializes in emerging tax issue and provides tax strategy and planning advice to clients on tax changes and developing areas of tax law.
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