The Internal Revenue Service (IRS) recently released Notice 2020-75, stating that proposed regulations will be forthcoming indicating that when a state or local jurisdiction imposes a tax at the entity level, the tax will not be subjected to the deduction limitation on state and local taxes that was part of the Tax Cuts and Jobs Act (TCJA) enacted in 2017. Historically, individual taxpayers have been able to claim an itemized deduction for state and local taxes paid. As a result of the TCJA, this deduction is now limited to $10,000 per individual taxpayer. In response to this, several states have enacted legislation to tax pass-through entities (PTE) at the entity level rather than passing the income to owners on a K-1 and subjecting the owners to tax. For federal and most state purposes, entities such as Partnerships and S-corporations have historically received “pass-through” treatment rather than being taxed at the entity level.
Certain states such as Tennessee and Texas have historically taxed PTEs at the entity level. Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island and Wisconsin are several states that have recently made elections available to PTEs to be taxed at the entity level rather than receive pass through treatment.
The benefit of this election is that the entire amount of tax from these states can be deducted in determining federal taxable income. This potentially prevents some of the deduction from being disallowed by the state and local taxes (SALT) limitation imposed by the TCJA. However, owners of PTEs should carefully model the benefit of making these elections. Typically, individual taxpayers are able to claim a credit against tax from their resident states for any non-resident state tax paid. However, this credit will likely not be available to individual taxpayers for taxes that are paid at the entity level by the PTE. Whether making the election will ultimately benefit the owners of a PTE is a function of several items, including state of residency of the owner, level of income apportioned by the PTE to states in which the election is available, tax rates of all states impacted, etc. Furthermore, it is likely that the election might create a benefit for certain owners of a PTE and a detriment for other owners of the same PTE.
Entity level taxes do not include state composite or nonresident withholding taxes paid by a PTE. These are taxes paid by a PTE on behalf of nonresident owners. The PTE does not receive a deduction for these taxes, and individuals claiming an itemized deduction for these taxes will have to consider the state and local tax limitation.
It is important that PTEs and their respective owners analyze whether there is a benefit in making the PTE election in states that allow for it. We recommend contacting your DHG Tax Advisor for further analysis or reach out to us directly at firstname.lastname@example.org.