Complexities continue to emerge for state pass-through entity taxes — proceed with caution

Calendar year 2021 has continued the trend of pass-through entity (PTE) tax proposals. With the fast approaching state tax compliance deadlines, PTEs and their owners are intensifying their attention on these taxes. PTEs and their owners should take these taxes into account when determining the impacts at the entity and owner levels. In addition, understanding relevant fact patterns is necessary when analyzing potential accounting for income tax considerations. 

As background, starting with Connecticut in 2018, a number of states have enacted PTE taxes as a ‘workaround’ for the $10,000 individual state and local tax itemized deduction limitation set by the Tax Cuts and Jobs Act of 2017 for owners of PTEs. While initially there was some question about whether or not PTE tax paid would be allowed as a deduction in computing an entity’s non-separately stated taxable income, some of those concerns were resolved by IRS Notice 2020-75. 

Notice 2020-75 informed taxpayers of forthcoming proposed regulations designed to clarify that state and local income taxes imposed on, and paid by, a partnership or an S corporation on its income are allowed as deductions in computing the entity’s non-separately stated income or loss for the tax year of payment. Under the regulations, partnerships and S corps would be able to deduct state and local income taxes against ordinary income, with no addback required at the individual partner or shareholder level. 

As of March 2021, nine states have enacted PTE taxes, with additional states having proposed legislation this year, including California and New York. Many of these PTE tax regimes are elective, as opposed to mandatory. 

Action item: The specific PTE tiered structure and resident and non-resident owner-types will drive the state tax issues that must be analyzed for purposes of considering opting into the various elective state PTE tax regimes. Some key considerations include: 

• Resident state credit for taxes paid: To the extent that the states do not allow a credit to their resident individual income taxpayers for entity-level taxes paid by a PTE, the owners effectively would be trading away a state credit for a federal deduction. Understanding that the impact on owners in low- or no-tax jurisdictions may differ from the impact on owners in high-tax states is essential. Additionally, whether the owner is an individual, corporation, partnership, or tax-exempt entity may have a significant effect on the federal benefit of these PTE taxes (and may limit the ability to elect into these tax regimes). By electing to be subject to an optional PTE tax, a taxpayer may create filing obligations or a tax expense that otherwise would not exist. 
  
• Double taxation concerns: To prevent double state taxation at the owner level, either a state tax credit or an exclusion of PTE income typically is allowed in calculating taxable income at the owner level for states imposing a PTE tax. Each state’s credit or exclusion mechanism should be included in any analysis performed for the owners. 
  
• Combined filing: Whether and how a PTE should be included in a combined return has only been addressed by a few states. If a PTE is included in a combined return, it may affect the group's income, apportionment, or other tax characteristics. 
  
• Tax accounting considerations: ASC 740 addresses how companies should account for and report the effects of ‘taxes based on income’ under US GAAP. The unique characteristics of the various PTE taxes can create complexity when determining whether a particular tax is based on income. 

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