Passthrough entity tax elections are a hot topic these days, with numerous states passing this kind of legislation in recent years. What’s the concept behind them, and why is there such a flurry of passthrough entity (PTE) election activity right now? More to the point, why do they matter to you—or should you care at all? Good questions all, so let’s answer them one by one.
What are passthrough entity tax elections?
Passthrough entity tax elections allow owners of certain businesses that are structured as passthrough entities to pay state taxes on income the business earns at the entity or “business” level.
That approach marks a sharp break from the longstanding policy that income from PTEs “passes through” to individual owners, members, and partners in these organizations, along with the tax liability associated with their respective portions of the income.
Why are so many states passing PTE election laws?
As of April 2022, nearly half of U.S. states had passed PTE tax election laws, with several more considering proposed legislation. The reason we’re seeing so much activity in this area is that PTE elections serve as a workaround to the federal cap on deductions for state and local taxes.
When the Tax Cuts and Jobs Act passed in 2017, it limited previously uncapped SALT deduction to $10,000 per year. This created a significant tax increase for many taxpayers, especially those with high state taxes—which are often home to areas with high local taxes. PTE elections represent the most effective strategy to date that states have found to alleviate some of this added tax burden on their residents.
What benefits do PTE elections offer?
IRS regulations haven’t necessarily changed; owners are always responsible for paying the federal tax due on their share of a PTE’s taxable income.
However, in states that have implemented PTE tax election policies, owners of eligible PTEs can choose to shift liability for state taxes to the entity or “business” itself rather than the individual owners. The payment of income taxes at the entity level allows the business to take a deduction on their federal income tax return for taxes paid to the states which ultimately reduces the taxable income that is passed through to the owners. Less taxable income to the owners means less income tax.
Is a PTE election right for you?
As you explore the idea of a PTE election make sure to consider questions like:
- Does the election apply to all members, or can individual owners opt-out?
- Will making the election impact the entity’s tax base?
- How might it interact with net operating losses or other tax considerations?
- Are there additional risks?
PTE tax elections represent an opportunity that, in the right circumstances, can offer substantial benefit. But the potential ramifications of making an election are numerous and far-reaching, so it’s imperative to discuss the issue with all shareholders and work closely with a qualified tax advisor to understand all the consequences before taking action.
If you think a PTE election may be right for your business, contact your Mauldin & Jenkins advisor today for guidance.