The $10,000 SALT deduction cap in Section 164(b)(6) of the tax code has been the topic du jour for many SALT tax practitioners and individual taxpayers subject to the limitation. Ultimately, the groans of those individual taxpayers in high-income tax states led to the now-complex patchwork of state laws seeking to create a workaround to the SALT deduction cap using a passthrough entity tax—a topic that never seems to get old. This article focuses on potential pitfalls and strategies taxpayers should consider given the variations of PTE tax rules across the country.
Buckle Up and Let the PTE Fun Begin
Connecticut was the first state to pass a PTE tax in 2018. Two years later, the IRS issued Notice 2020-75, which effectively blessed the state PTE tax as a workaround for the SALT cap. Specifically, it provided that partnerships and S corporations may fully deduct their SALT payment at the entity level in computing their non-separately stated taxable income or loss. Notice 2020-75 also noted the IRS’ intent to issue proposed regulations regarding the deduction of passthroughs for SALT payments, but we have yet to see additional guidance.
Considering the IRS has allowed a full federal deduction of SALT payments, 29 states have enacted PTE taxes. So how do they work?
The idea behind these new taxes is that the passthrough entity itself pays the tax, rather than the tax being paid by the passthrough owners. In turn, the passthrough owners then receive—in most cases—a dollar-for-dollar credit to offset their individual income taxes.
For state revenue purposes, the PTE tax regime is supposed to be revenue neutral, meaning the taxes collected at the passthrough entity level and credited to the passthrough owners are intended to be equal. Thus, states see PTE taxes as a win-win for their residents who can use these new tax regimes, because they generally won’t be restrained by the $10,000 SALT cap on any income earned by a passthrough business.
This description is, of course, an oversimplification, and the devil is always in the details. There are so many details when it comes to PTE taxes. Because states adopted PTE taxes quickly without “model” legislation, the specifics of each are different, which is one of the main issues to be wary of when it comes to the PTE taxes. Each state that enacted a PTE tax put its own spin on the general concept. If you’re considering trying to use the PTE tax and the PTE at issue operates in multiple states, you’ll have to review each state’s specific statutes and regulations. We can’t stress this enough—there are no short cuts.
With this general background in mind, and an understanding that each state’s PTE tax is different and unique, we will discuss a few of the specific pitfalls.
Do I Have to Make an Election?
One interesting difference between states is whether the PTE is mandatory or elective and, even then, the application of the rules often differs based on the type of taxpayer. Connecticut requires passthrough entities to pay an entity level tax. Other jurisdictions, like Washington, D.C., piggyback off existing entity-level taxes, such as unincorporated business tax, to effectively make the PTE tax mandatory.
States such as Maryland blend existing entity-level taxes with new PTE taxes, which makes the PTE tax elective for Maryland residents and mandatory for nonresidents. In other states, PTE taxes are purely elective. But electing into this new regime may cut off certain PTE payment and filing options that provide administrative ease for nonresident passthrough owners.
What this means for taxpayers is that there’s no one-size-fits-all solution for PTE owners. A Connecticut nonresident partner may not benefit from the PTE tax but will have to comply. Thus, the partnership may have to make the partner “whole” for any taxes incurred on behalf of that partner regardless of whether the partner benefited from the deduction.
The good news is that most states’ PTE taxes are elective. In California, each PTE owner may opt in or out annually if the PTE makes the election. In many other states, however, it’s an all-or-nothing proposition, but the PTE does have a choice as to whether to elect into the regime.
Even in those states where the entity doesn’t need to use the PTE tax, the rules for which entities or partners may elect aren’t cut and dry. Many states don’t allow tiered passthrough entities to elect into the PTE tax regime, and some have rules restricting the election based on the types of partners (individuals, corporations, trusts) in the passthrough entity. Other states have specific rules about what percentage of partners must agree to the election and what agreements must be in place.
The first decision point is whether a PTE is required or whether a PTE can elect into a state’s PTE tax regime. For PTEs operating in a single state, this will generally be a simple decision. But a multistate PTE will first have to determine the specific rules in all states in which it is doing business to determine whether it will be subject to a mandatory PTE tax, or whether the PTE is eligible to elect into the PTE tax regime. Considering the variation among states on this issue alone and, depending on the number of states the PTE is doing business in, this may very well be a complicated determination.
Can Nonresidents Still Rely on Composite Returns?
Once a taxpayer elects (or must elect) to join a PTE regime, the complexities of administering the PTE tax begin. For many nonresident owners of PTEs, a saving grace from the burden of compliance is using a composite return for filing in multiple jurisdictions. Often, the tradeoff for filing a composite return is that the nonresident PTE owner must give up certain tax attributes in exchange for filing a simple form with the state. That tradeoff, in states such as Alabama and New York, including giving up the PTE tax credit. In contrast, Massachusetts and New Jersey specifically carve out the PTE tax credit from composite returns, allowing a nonresident to enjoy the benefits of the credit despite filing a composite return.
This hodgepodge of composite return rules can create a headache when it comes to compliance. A PTE that makes the election may need to inform electing owners to file individual returns in states such as Alabama and New York if the owner wishes to benefit from the election. In other states, the PTE may file a composite return. PTE tax compliance is already tricky, but the PTE tax election adds another layer of complexity.
What About Credits for Taxes Paid to Another State?
If your head isn’t spinning already, the multistate TPAS credit rules for the PTE tax will surely have you reaching for your vertigo medication. The availability of the TPAS credit may be one of the most critical components for whether a PTE owner decides to make an election, because denying a TPAS credit decreases the benefit of the PTE tax regime.
Illinois, for example, doesn’t allow for an Ohio PTE tax credit. If an Illinois resident receives a net federal benefit from making a PTE tax election in multiple states, but then is double taxed due to being denied a credit of Ohio PTE taxes, the Illinois resident must factor in the double taxation when considering their overall benefit. The hassle, with all the layers discussed above, may not be worth it for the Illinois resident if the overall benefit is quite small when they layer in potential double taxation.
Another wrinkle is what order a taxpayer must apply the PTE tax credit when compared to other credits. California, for example, provides that for tax years beginning on or after Jan. 1, 2022, the PTE tax credit applies after the TPAS credit. This amendment to California’s credit ordering rules for the PTE tax credit was welcome relief for its residents because, under the prior rule, the PTE tax credit had to be used before the TPAS credit, leaving many California residents with TPAS that wasn’t subject to a carryover or a refund. Many states that provide a PTE tax credit, however, don’t provide clear guidance like California does.
What’s Next for PTE Taxes?
Despite the overwhelming complexities with states’ variations of PTE taxes, states should be applauded for trying to enact legislation that allows its residents to maximize their federal tax deductions. Section 164(b)(6) is scheduled to sunset in 2025, but that date may be extended.
So what should taxpayers be thinking about over the next few years (or maybe beyond) before making a PTE election? A lot. Although the election appears to benefit taxpayers on its face, because of the increased federal tax deduction, the overlay of multistate variations and increased compliance burden may diminish the benefit significantly.
Along with the issues raised above, taxpayers and their PTEs also might have to consider whether to revise their partnership agreements to clearly spell out PTE tax responsibilities. For most PTEs, their tax regimes didn’t exist when the partnership agreements were drafted, and those agreements may need to describe how the PTE will decide whether to elect into a state’s PTE tax and how the owners and the PTE should handle revoking any such election. Other issues that may crop up include understanding the state tax withholding requirements, dealing with disgruntled partners forced into the election by other partners, and deciding what to do if or when Section 164(b)(6) does sunset.
PTE tax regimes are generally good for PTE owners. But the PTE will have to dig in to determine whether the ultimate benefit of using the state’s PTE taxes. Maybe even more importantly, the PTE and its owners will need to analyze whether that benefit outweighs the compliance burdens of dealing with the complexities of multistate PTE taxes. Ultimately, this will require a spreadsheet—and each PTE will have to do the math, because it’s not as easy as just checking a box.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Shail Shah is a shareholder at Greenberg Traurig LLP in San Francisco. His practice focuses on complex California tax planning and representation in front of various boards and offices as well as administrative and judicial adjudicating forums at the state and local levels.
Nikki Dobay is a shareholder in Greenberg Traurig’s Portland, Ore., and Sacramento, Calif., offices. She focuses on multistate tax issues and controversy matters and state and local tax policy matters from a government and legislative process perspective.
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