As discussed in Part I of this article, at least 22 states have adopted a pass-through entity tax—or PTET—election for small business owner taxpayers seeking to avoid the $10,000 federal deduction limit for state and local taxes. Most state PTET elections follow the standard workaround formula for the SALT cap, which was introduced under the 2017 Tax Cuts and Jobs Act. Under the formula, a small business may elect to pay tax at the entity level, and a corresponding credit is allowed at the partner, member, or shareholder level. But important differences between the state programs can spur planning pitfalls for taxpayers.
Taxpayers should separately evaluate state entity-level elections in context of both their specific tax structure, individual filing positions of members, and availability of credits in nonresident states to determine if the election would provide a favorable outcome. Eligibility is a threshold issue; many states do not allow the election for larger pass-through entities, while other states allow nearly any type of pass-through entity to elect in. Some states, like California, allow individual members to opt into the election. States like New York have all-or-nothing elections, in which the entity may elect in to the tax without the consent of all members.
The value of offsetting benefits for partners, members, and shareholders also varies among state PTET elections. In many cases, offsetting credits are directly equal to the value of tax paid at the entity level. Other states only provide a partial offsetting credit for members. In states like California, where the 9.3% net tax corresponds to only one of the state’s graduated tax rates, corresponding credits may be more or less valuable depending on the taxpayer’s individual filing position. Also, practitioners should be on alert for different offsetting credits applicable to residents versus nonresident members. Maryland’s PTET, for example, initially offered no offsetting credits for nonmembers.
Although the benefits may be substantial, pass-through business taxpayers with multistate operations or with members in multiple states will face more complicated compliance and should tread carefully when deciding whether to make entity-level elections. Paying entity-level tax in one state may affect the individual tax returns of each partner, member, or shareholder in other states where the business is subject to a filing requirement, particularly in claiming credits for similar entity-level taxes paid to another state.
Some states will not permit credits for taxes paid to other states if paid at the entity level. For example, a taxpayer in Maine that owned and operated a Connecticut S corporation was denied a credit against his Maine income tax liability for Connecticut taxes imposed on and paid by the entity. The Maine Board of Tax Appeals, in Individual Taxpayer v. Maine Revenue Servs., Docket No BTA-2020-1, ruled that the state credit for taxes paid to another jurisdiction excluded taxes imposed on and paid by a business entity. The board further found that this exclusion, and the denial of an individual offsetting credit, did not violate the U.S. commerce clause. The taxpayer’s plight in this case was heightened because Connecticut’s SALT cap workaround mechanism is mandatory for certain pass-through entities, rather than elective, like every other PTET adopted thus far.
Considerable variation among different state SALT cap workarounds could spell out additional heartburn for practitioners tasked with navigating a slew of emerging regulatory guidance corresponding with each new workaround statute. In addition to compliance with each state election and reporting of credits, practitioners must also plan for withholding and estimated tax payments in some states—this includes requesting refunds for overpaid estimated taxes that may have previously been paid by individual owners and how PTET credits may carry forward if unused by the individual owner in the tax year paid by the entity. Business entities making the election may also expect additional compliance considerations in preparing each state Form K-1.
The future of the SALT cap is uncertain, creating additional planning challenges for pass-through business owners. As adopted under the Tax Cuts and Jobs Act, the cap is set to expire at the end of 2025.
The SALT cap has been debated by federal policy makers since its adoption. Advocates on one side continue to push for repeal, and advocates on the other side push for extension into 2026 and beyond. The most recent version of the Build Back Better Act passed by the House of Representatives increased the current $10,000 deduction limit to $80,000, and $40,000 for married taxpayers filing separately and trusts and estates. To date, the most recent efforts to eliminate the SALT cap do not appear to have gained sufficient traction to pass. The Senate Finance Committee recently released updates to the bill, including eliminating the House amendment increasing the SALT cap limit.
States’ Request for U.S. Supreme Court Review
As noted in Part I, the states of New York, New Jersey, Connecticut, and Maryland recently filed a petition for writ of certiorari with the U.S. Supreme Court in New York v. Yellen requesting that the court determine whether the SALT cap violates the 10th and 16th amendments of the U.S. Constitution. The crux of the states’ argument that the Constitution requires a full SALT deduction to ensure that federal income tax does not infringe on states’ sovereign taxation powers. The states’ federalism claims had previously been rejected by the U.S. Court of Appeals for the Second Circuit, and the states have requested the Supreme Court to exercise its discretion to accept the case for review.
Overall, the trend in states to adopting PTETs as a workaround to the SALT cap raises significant opportunities, along with increased complexity, for taxpayers who may be eligible. If the SALT cap expires, is suspended, or is repealed, taxpayers may be stuck with entity-level taxes in states where the election is irrevocable, like Ohio—although these states would presumably take legislative action to prevent such unintended results. States may also become more comfortable imposing entity-level taxes on pass-through business structures.
Businesses structured as pass-through entities should continue to monitor the progress of these SALT cap issues, and act quickly to consider whether they may benefit from PTET elections in states where available.
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.
William Gorrod is a partner at Baker Botts’ San Francisco office, where he focuses on state and local tax planning, compliance, and corporate transactions on a multistate basis. He also represents clients in state and local tax controversies throughout the United States.
Renn Neilson is partner at Baker Botts’ Houston office, where he is the firmwide chair of the state and local tax section and a member of the oil and gas M&A team. His practice focuses on state and local taxation, incentives, and unclaimed property.
Matthew Larsen is a partner at Baker Botts’ Dallas office, where he represents clients in state and local tax planning, controversies, incentives and legislation in Texas and numerous other states. He assists clients in structuring operations and transactions to reduce state and local taxes and advises on real estate transactions, asset and stock sales, mergers, service transactions, and development projects.
Jon Feldhammer is a partner at Baker Botts’ San Francisco office. He is a former IRS senior trial attorney and works on complex tax controversies for clients before the IRS, California Franchise Tax Board and other state agencies. He advises clients on tax compliance issues and assists corporations, partnerships and individuals in navigating the challenging tax environments.
Ali Foyt is an associate at Baker Botts’ Houston office, where she advises and represents clients in a broad range of planning and controversy matters related to state and local taxes around the country. She regularly defends taxpayers in tax controversy and assists clients with property tax incentive negotiations and strategic multistate planning.
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