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A recent tax planning strategy has emerged which benefits owners of many businesses that are structured as partnerships, LLCs, LLPs, or S-corporations. A carefully planned analysis of the business’ tax filings can provide a way to reduce an owners’ taxable income from the business due to the adoption of changes in how the entity reports its taxable income in the states where it files returns. In this article we’ll walk through why this opportunity exists and how to work with your tax advisors to ensure you and your business are benefiting.
Let’s start with some background information. In late 2017, President Trump signed the federal Tax Cuts and Jobs Act (or “TCJA”) into law. TCJA was one of the largest federal tax reforms enacted since the 1986 tax act from the Reagan administration. TCJA brought with it numerous reductions in personal income tax rates, a 21% federal tax rate for C-corporations, and other provisions widely viewed as business friendly. As with any tax reform, there were some areas viewed as less taxpayer friendly that came along with TCJA.
One provision that fell into this category was a $10,000 limitation on the amount of state taxes an individual could recognize as an itemized deduction on their personal income tax filings with the IRS. Initially this provision was seen as a tax cost borne mainly by individuals that live/work in states with relatively high tax rates on property (e.g. California, Texas and many Northeastern states).
The $10,000 state tax deduction limitation on individuals’ federal income tax filings applied to all state taxes paid. Many individuals exceeded the $10,000 cap solely on property taxes paid before receiving any deduction for state income taxes paid on an owner’s share of business earnings reported on their IRS Form K-1.
As the dust began to settle on TCJA and legislators at the federal and state level received negative feedback on this provision a few ideas began to bubble up. At the federal level, it became clear that the relative cost to eliminate the $10,000 cap on state tax deductions was severe enough that Congress would not enact legislation to remove it in the near term. At the state level, individuals in high tax states looked to their local politicians to reduce state/local tax rates to offset this new federal tax cost.
An idea came to the forefront that could be enacted at the state level, which would allow pass-through business owners to receive a federal benefit for state taxes paid on their business earnings without drastically reducing the states’ tax collections. The idea was to create a new form of state income tax filing for pass-through businesses which would shift the legal obligation to pay state income taxes directly to the business, not the owner.
The state “pass-through entity tax”, or PTET, election allows the business to claim a state tax deduction on its own federal income tax returns and reduces the amount of taxable income reported on the IRS Form K-1 received by the owners each year. In November 2020 the IRS released Notice 2020-75 which acknowledged the enactment of a state PTET filing for pass-through businesses as a reasonable method for the business to pay its state income taxes and reduce the owners’ federal taxable income for those state taxes paid by the business directly.
This announcement has set off a chain of events which has now led to approximately 30 states adopting a PTET election option for certain businesses to pay their state income taxes directly and thus provide a federal tax savings opportunity for the business owners.
As you consider the PTET there are a few groups of pass-through entities that may not find this election beneficial. This is where having a tax planning discussion with your tax advisor is critical. First, if your business will generate net losses the PTET likely isn’t a good idea. The entity would have no state tax burden to pay and owners would lose out on using losses to potentially offset other sources of income. Second, if you own multiple pass-through businesses with a combination of taxable income and losses you’ll want to map out whether the PTET makes sense once you offset losses and income on your personal return filing.
A great tax advisor can help you model this and determine the best outcome. Also, if you live in one state but your pass-through entity generates its taxable income in another state, your tax advisor will want to make sure a PTET election in the business’ state of operation will trigger an offsetting state tax credit in your home state. This avoids the risk that you pay state income tax on the same earnings twice.
Finally, if your business operates as a C-corporation you can ignore this PTET idea altogether. C-corporations already pay their state income taxes directly and there isn’t any limitation on a C-corporation’s ability to deduct state taxes paid on its federal return filings.
Several local state legislatures began adopting various forms of PTET election regimes in 2021 and early 2022. Let’s talk about how these rules may apply to North and South Carolina based entities.
North Carolina – Beginning with tax years that begin on January 1, 2022, a pass-through entity with operations in North Carolina can elect to file a North Carolina PTET return. This election can be made on the business’ 2022 tax return by simply filing the applicable tax form. If your entity plans to extend its 2022 North Carolina filing, you can make this election with the extended return filing in fall 2023. You can also opt out of the PTET filing on an annual basis if your facts change in future years and PTET no longer works for you. The tax rate that would be assessed on a business electing PTET status will be the same as the NC individual tax rate as well.
South Carolina – The SC legislature adopted its PTET regime in summer 2021 and it is applicable for any tax year beginning on or after January 1, 2021. Interested companies should consult a tax advisor about these changes to make sure you’ve considered whether PTET filings may provide tax savings to you. The SC PTET election would apply to most pass-through entities operating in the state.
Qualifying entities will be taxed at a 3% South Carolina tax rate on their earnings. The SC PTET does, however, exclude income from sources other than “active trade or business income”. If you own an entity that primarily performs professional services (e.g. attorneys, physicians, accountants), you’ll want to discuss the SC PTET limitations with your tax advisor to determine its application to your operations.
In summary, the recent enactment of Pass-Through Entity Tax filing regimes in most US states provides an opportunity for owners of profitable businesses to reduce their federal tax bill moving forward. If you own an interest in a partnership, LLC, S-corporation or similar entity, now is a great time to ask your tax advisor about the PTET for your upcoming 2022 filings.
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About the Author
Jason Pritchard is a partner in GreerWalker’s Greenville, SC tax practice. Prior to joining the firm, Jason was most recently responsible for the oversight of state & local tax accounting and compliance at a global top five financial institution.
In addition, Jason spent 10+ years at a Fortune 50 retail company where he was responsible for all aspects of federal, state & international taxation. Jason has 20+ years of experience evaluating and resolving US federal and state audit issues, the financial evaluation of proposed mergers and acquisitions and in the development and implementation of strategic business technology. Jason also works with clients to identify and implement federal, state & local tax and development incentives.
For questions and guidance about these changes, reach out to Jason at firstname.lastname@example.org or (864) 752-0084.
This article was originally published in the 2022 Catalyst Construction Journal.