A number of states have enacted pass-through entity taxes (PTETs) as a workaround for reductions in SALT deductions—a development that could potentially affect many clients.

The Tax Cuts and Jobs Act of 2017 capped the individual state and local tax (SALT) itemized deduction limitation at $10,000 for, among others, owners of pass-through entities (PTEs). While initially there was some question about whether PTE taxes would be allowed as a deduction in computing an entity’s non-separately stated taxable income, the IRS has answered some of these questions.

Proposed regulations aim to clarify that state and local income taxes paid by a partnership or an S corporation are allowed as deductions in computing the entity’s non-separately stated income or loss for a tax year. Partnerships and S corps can deduct state and local taxes paid at the entity level with no add-back at the individual/shareholder level.

“This deduction reduces the amount of income reported to the individual/shareholder by the pass-through entity,” said Geoff Christian, managing director of national, state and local taxes at CBIZ MHM in Greenville, S.C. “The [taxpayer] is essentially reducing taxable income by these state and local taxes even though the individual’s state and local tax deduction can’t exceed $10,000.”

New York and California recently joined Alabama, Arkansas, Idaho, Louisiana, Maryland, Massachusetts, Minnesota, New Jersey, Oklahoma, Rhode Island and Wisconsin in enacting their own elective varieties of PTET. Connecticut’s tax is mandatory. Arizona, Colorado and Oregon are looking to allow PTETs in future tax years.

State legislation is constantly changing and by no means does the list seem final yet. Some PTET legislation is also scheduled to sunset in a few years.

“The basic concept is to impose a state tax on the pass-through entity business," in which the business will be allowed to deduct as an ordinary business expense for federal purposes, said Tom Corrie, tax attorney, principal and co-leader of Friedman’s state and local tax practice in New York.

Individual partners, members or S corporation shareholders are then permitted a credit against their personal income tax liabilities for their portion of the taxes paid at the entity level.

“The entity pays the tax and gets a deduction and the individual owners get a credit against their state income tax liability,” Corrie said. “The advantage of a PTET regime is that it ultimately allows the owners to credit their portion of the state tax paid by the entity against their personal income tax liability, and thus avoid the federal $10,000 limitation. The entity is not subject to that limitation, so it’s permitted to deduct state and local taxes for federal purposes.”

State statutes in this matter differ. Corrie cited Connecticut, New Jersey and New York as examples of PTET provisions that require careful planning.

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