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State and Local Tax

Multistate Trends: What Pass-Throughs Need to Know About the Entity-Level Tax Election

Jequetta Byrd, Checkpoint Catalyst, J.D., MTax  

Niki Ford, J.D., LL.M.  Checkpoint Catalyst Editor/Author

Kathryn A. Burns, Checkpoint Catalyst, J.D., LL.M.,  

· 16 minute read

Jequetta Byrd, Checkpoint Catalyst, J.D., MTax  

Niki Ford, J.D., LL.M.  Checkpoint Catalyst Editor/Author

Kathryn A. Burns, Checkpoint Catalyst, J.D., LL.M.,  

· 16 minute read

Pass-through entity-level tax elections pose significant opportunities and risks for pass-through entities and their owners across the states. As of the first of the year, thirty-six states and one locality (New York City) allow pass-through entities to elect to pay income tax at the entity level rather than the partner or shareholder level. Pending legislation in three additional states—Maine, Pennsylvania, and Vermont—would enact an elective pass-through entity level tax. Of the remaining jurisdictions, only Delaware, the District of Columbia, and North Dakota impose a personal income tax on income that flows through to a partner or shareholder from a pass-through entity.

While the trend toward allowing pass-through entities to elect to pay tax at the entity level began as a way to circumvent federal provisions limiting an individual’s deduction of state and local taxes to $10,000 for tax years beginning in 2018 through 2025, this “state and local tax (SALT) cap workaround” has become a major business decision all its own. Given the varied nature of each individual state’s pass-through entity-level tax provisions, taxpayers should carefully weigh the benefits and implications to all of their owners in each state prior to making an election. This article from Checkpoint Catalyst provides a high-level overview of  trends and considerations around the pass-through entity-level election across the states. These issues include: which entities will qualify for the election, the requirements for making the election, the mechanics of calculating the tax, and the availability of adjustments or credits to avoid double taxation. For a granular breakdown of each state’s approach, see new Checkpoint Catalyst Topic #1014, “SALT Cap Workaround” —Pass-Through Entity-Level Tax.

The federal limit.

Five years ago, the Tax Cuts and Jobs Act (TCJA, P.L. 115-97, 12/22/2017), imposed a $10,000 limit ($5,000 for married filing separately) on the state and local deduction allowed to individual taxpayers in calculating their federal taxable income.1 The $10,000 limitation applies to tax years beginning on or after January 1, 2018, but before January 1, 2026, and thus is set to expire for tax years after 2025. This limitation does not apply to corporate taxpayers.2 Before the TCJA, both individual taxpayers that itemized their deductions and corporate taxpayers could deduct 100% of state and local taxes paid or accrued during the tax year.3

Invention of the workaround.

Shortly after the law was passed, states began searching for ways to circumvent the limit on an individual’s deduction of state and local taxes through what have become known as SALT cap workarounds. Initially, a few states attempted to create charitable deductions for state taxes; however, this approach was essentially invalidated by the IRS through amendments to Reg. § 1.170A-1(h)(3). In April 2018, Connecticut became the first state to enact a pass-through entity-level tax as a SALT cap workaround.4 Imposing the tax at the entity level shifts the deduction for the pass-through entity’s state tax expense from the individual owners of the pass-through entity by creating a state tax expense and deduction at the pass-through entity level which is not subject to the $10,000 cap.

Adoption by other states.

Many other states followed Connecticut’s lead, particularly after the IRS released Notice 2020-75, which advised taxpayers that state and local taxes imposed on and paid by a partnership or an S corporation can be deducted by the partnership or S corporation in computing its non-separately stated federal taxable income or loss. Under the IRS guidance, each partner’s or shareholder’s distributive share of non-separately stated income reflects the entity-level state tax deduction, and the partner’s or shareholder’s distributed share of the tax is not a separately stated item which would be subject to the $10,000 cap. Thus, a state’s imposition of tax at the entity level is an effective workaround to the federal limit on the individual state and local tax deduction.

Election limitations and exceptions.

Generally, a state election to pay tax at the entity level can be made by entities treated for federal tax purposes as partnerships (other than publicly traded partnerships) or S corporations; however, many states provide limitations or exceptions to this general rule. For example, Arkansas requires a pass-through entity to be “engaged in carrying on a business for profit” and to be subject to an Arkansas return filing requirement in order to make the election.5 Louisiana prohibits an entity that files a composite partnership return from making the election.6 Minnesota requires the pass-through entity to have at least one qualifying owner, defined by Minnesota law to mean a resident or nonresident individual, estate, certain type of trust, or, as of 2023, single member disregarded entity with a qualifying owner.7 New Jersey requires the partnership or S corporation to have at least one member subject to the New Jersey gross income tax,8 and South Carolina requires all owners of the partnership or S corporation to be qualified owners (defined in South Carolina to mean individuals, estates, trusts, or any other entity other than corporate income taxpayers, electing small business trusts, or tax-exempt entities).9

Years election can be made.

In most states, the elective tax is effective indefinitely, but several states limit the election to the tax years in which the federal $10,000 SALT cap applies—meaning that the election is no longer available for tax years beginning on or after January 1, 2026; other states provide that the election provisions are automatically repealed if the federal SALT cap provisions no longer apply.10 Typically, all qualified owners of the pass-through entity are bound by an election; however, states may limit application of the election to certain owners.11 Arizona allows pass-through entity owners to opt out of the election to pay tax at the entity level and requires pass-through entities that intend make an election to give their owners 60 days notice of their right to opt out.12

Variable applicability periods and revocation rules.

The years an election is applicable, and the ability to revoke an election once it is made, can also vary state by state. Most states require an annual election by an authorized representative of the pass-through entity and, once made, do not allow the election to be revoked for that tax year,13 but there are exceptions to this general rule. For instance, in Louisiana and Mississippi, once the election is made it remains in effect for future tax years until it is affirmatively revoked.14 For tax years beginning after 2022, Louisiana allows a pass-through entity to prospectively terminate its Louisiana election; however, a terminating pass-through entity cannot make another election for the next five tax years.15 Several states require the election to have the approval of more than half of the partners or shareholders based on ownership interest.16 Further, certain states (such as Colorado and Nebraska) allow a taxpayer to make a retroactive election to pay the pass-through entity tax for earlier tax years.17

Differing election forms and mechanics.

Taxpayers should also be aware of the mechanics for making the election. In several states, the election is made on the pass-through entity’s annual return.18 In other states, a specific election form may be allowed or required.19 In still others, a pass-through entity will be considered to have made the election simply by paying the pass-through entity level tax.20 Also, states may provide different rules for the year the pass-through entity tax was enacted and for subsequent years, or may allow taxpayers to file amended returns for certain years (and not others) to make or revoke the pass-through entity-level tax election.21

Varying rates.

Many states impose tax at the highest individual tax rate, as in Arizona, Iowa, and Missouri;22 however, a number of states take different approaches. For example, Arkansas applies a reduced rate to capital gains,23 Colorado and Idaho impose the pass-through entity tax at the corporate income tax rate,24 New Mexico imposes tax at the higher of the maximum individual rate or the maximum corporate tax rate,25 New Jersey and New York impose the pass-through entity tax at a variable or graduated rate,26 and South Carolina uses a flat 3% rate.27

Divergent base calculation rules.

Rules for calculating the pass-through entity-level tax base differ significantly state by state. Each state’s pass-through entity tax provisions specifically define the pass-through entity level tax base to which the rate applies, and the base computation and sourcing rules may vary from those applicable at the partner or shareholder level. For example, in Arizona and Utah, the pass-through entity calculates its tax base by adding the entire portion of the pass-through entity’s taxable income that is attributable to resident partners or shareholders and the portion of the entity’s taxable income derived from sources in the state that is attributable to nonresident partners or shareholders.28 However, many states exclude from the tax base the portion of taxable income attributable to specified categories of partners or shareholders. For example, Arizona provides that the pass-through entity-level tax does not apply to taxable income attributable to a partner or shareholder that is not an individual, estate, or trust, or to the taxable income of partners or shareholders that opt-out of the pass-through entity tax election.29 California imposes tax on the pro rata or distributive share of income and any guaranteed payments of certain taxpayers subject to the California personal income tax.30 In Montana, electing entities are subject to tax on the distributive share of Montana source income for all owners that are individuals, estates, trusts, and pass-through entities, but can substitute this tax base for the entire distributive share of income of Montana resident owners.31 New Jersey imposes its elective pass-through entity tax on the sum of each member’s share of the entity’s distributive proceeds, but has redefined the definition of distributive proceeds three times since the passage of its alternative tax in 2020,32 and in South Carolina the election applies only to active trade or business income and deductions received by the owners of the pass-through business; non-active trade or business income is passed-through and taxed at the partner or shareholder level.33

Credits and adjustments to prevent double taxation.

Treatment of the owners of an electing pass-through entity also differs from state to state. In most states, owners of a pass-through entity can take a credit against their state income tax for a distributive or pro-rata share of the pass-through entity-level tax paid or accrued during the tax year. Many states allow a refund to the taxpayer of any excess credit, or instead permit the taxpayer to carry forward the available credit to future tax years. For example, in California the credit is nonrefundable, but taxpayers can carry forward unused credits for up to five years.34 Hawaii allows each member of an electing pass-through entity a credit for their pro-rata share of the pass-through entity tax paid, but credits that exceed the member’s tax liability are nonrefundable and cannot be carried forward.35 In Massachusetts, qualified persons may take a refundable credit equal to 90% of their share of the pass-through entity tax.36 Some states also allow resident taxpayers a credit for their share of pass-through entity-level taxes paid in other states. Typically, the provisions allowing for this credit provide that the other state’s pass-through entity-level tax must be substantially similar to the pass-through entity tax levied in that particular state.37 As an alternative to providing a credit for taxes paid at the entity level, states may require the owners of the pass-through entity to adjust their state taxable income to exclude their distributive share of income subject to tax at the pass-through entity level.38

Estimated tax payment compliance.

Pass-through entities electing to pay tax at the entity level must also consider whether the state estimated tax payment provisions apply to any taxes due. Pass-through entities that fail to comply with a state’s estimated tax payment provisions may be subject to interest and penalties for failure to pay taxes in the appropriate amount or by the appropriate due date.

The larger takeaway.

As highlighted in the discussion above, the opportunities and risks inherent in states’ pass-through entity-level tax laws lie in the intricate details, which vary widely from state to state. Pass-through entities and their owners and tax advisors must carefully consider each state’s rules for making the election and calculating the tax imposed on the pass-through entity in order to ensure that a valid election has been made and that making the election results in a benefit to the owners of the pass-through entity. In one sense, it may seem that the dust has settled now that so many states have enacted pass-through entity-level taxes, but with many of these taxes set to be repealed after the 2025 tax year or if the federal cap on the state and local tax deduction for individuals expires, keeping current in this changing area is likely to remain a challenge for years to come. Furthermore, even with the SALT cap set to expire in a few years, it remains a frequent subject of Congressional debate. Current proposed federal legislation in the House would raise the deduction cap to $20,000 for married taxpayers filing jointly (with income under $500,000), to eliminate the marriage penalty.

Checkpoint resources.

In recognition that multistate business interest in the SALT cap workaround may not be limited to pass-through entities treated as partnerships and S corporations, we have gathered our analysis on the pass-through entity-level tax into new state-specific Catalyst Topic #1014, “SALT Cap Workaround”—Pass-Through Entity-Level Tax, enabling customers to quickly navigate the information they need to make informed decisions on the state tax advantages and disadvantages of electing to be taxed at the entity level. The topic serves as a comprehensive advisory shortcut, providing an overview and analysis of each state’s laws, regulations, and official guidance on the elective pass-through entity-level taxes across the states.

For charts with clickable maps reflecting availability of the pass-through entity-level tax across the states, see the following Checkpoint State Charts, both of which can be previewed by Checkpoint Catalyst subscribers in text-only format in the Introduction to Checkpoint Catalyst Topic #1014, “SALT Cap Workaround”—Pass-Through Entity-Level Tax: State Imposes Entity Level Income Tax— Partnerships, and State Imposes Entity Level Income Tax S—Corporations.

Finally, for a detailed analysis of other state taxes that may apply to pass-through entities and the reporting responsibilities of pass-through entities across the states, see the multistate components of our federal partnership and S corporation topics:

  • Checkpoint Catalyst Topic #216:1000, State Treatment of Entity Classification/Disregarded Entities; and
  • Catalyst Topic 253:1000, State Taxation of S Corporation Income, Losses, Deductions, and Credits.

1 IRC § 164(a); IRC § 164(b).

2 IRC § 164(b)(6).

3 Former IRC § 164, eff. before 01/01/2018.

4 Initially mandatory in Connecticut, the pass-through entity-level tax is elective in the state for tax years beginning on or after January 1, 2024. Conn. Gen. Stat. 12-699(a), effective for tax years beginning on or after 01/01/2024.

5 Ark. Code Ann. 26-65-102(2)(A).

6 La. Rev. Stat. Ann. 61:1:1001(B)(4).

7 Minn. Stat. 289A.08, Subd. 7a(a)(3).

8 N.J. Rev. Stat. 54:10A:12-3(a).

9 S.C. Code Ann. 12-6-545(G).

10 See, e.g.,Cal. Rev. & Tax. Cd. § 19900(a)(1); Colo. Rev. Stat. § 39-22-343(2); ILCS Ch. 35 § 5/201(p); Iowa Code 422.16C(2); Minn. Stat. 289A.08, Subd. 7a(b); L. 2021 Chapter 589 § 3(1), amended by L. 2023 Chapter 399 § 1; Utah Code Ann. 59-10-1403.02(2)(a); and Va. Code Ann. 58-1-390.3(A).

11 See e.g.,Cal. Rev. & Tax. Cd. § 19900(c)(2); L. 2023, Act 50, § 2; Hawaii Tax Information Release No. 2023-03, 12/27/2023; Mass. Gen. L. Ch. 63D § 6; Minn. Stat. § 289A.08, Subd. 7a.(b); New Mexico, Frequently Asked Questions About Direct Taxation of Pass-through Entities, 01/27/2023.

12 Ariz. Rev. Stat. Ann. § 43-1014(D).

13 See e.g., Cal. Rev. & Tax. Cd. § 19900(d); Mo. Code Regs. Title 12 § 10-2.436(2); Massachusetts Technical Information Release No. 22-6, 03/18/2022; South Carolina Revenue Ruling No. 21-15, 12/02/2021.

14 La. Rev. Stat. Ann. § 47:287.732.2(A)(4).

15 La. Rev. Stat. Ann. § 47:287.732.2(A)(4)(d).

16 See, e.g., Ark. Code Ann. § 26-65-102(1); La. Admin. Code § 61:I.1001(B)(1); Minn. Stat. § 290A/08, Subd. 7(b); Wis. Stat. § 71.21(6)(a).

17 Colo. Rev. Stat. § 39-22-343(1)(c); Neb. Rev. Stat. § 77-2727(6)(h); Neb. Rev. Stat. § 77-2734.01(8)(h).

18 Cal. Rev. & Tax. Cd. § 19900(d); Illinois Publication 129, Pass-Through Entity Information, 11/01/2023; South Carolina Revenue Ruling No. 21-15, 12/02/2021.

19 Indiana Information Bulletin No. IT72B, 10/01/2023; Iowa, Pass-Through Entity Tax (PTET) 09/18/2023; Virginia Tax Bulletin No. 23-8, 10/03/2023; Md. Regs. Code § 03.04.07.03(A)(2).

20 See e.g., Utah Code Ann. § 29-10-1403.2(2)(d).

21 Massachusetts Technical Information Release No. 22-6, 03/18/2022; Minn. Stat. § 289.08, Subd. 7a(b); Minnesota, Pass-Through Entity (PTE) Tax, 07/27/2023.

22 Ariz. Rev. Stat. Ann. § 43-1014(A); Iowa Code § 422.116C(4)(a); Mo. Rev. Stat. § 143.436(3)(1); Mo. Rev. Stat. § 143.436(4)(1).

23 Ark. Code Ann. § 26-65-103(b)(1).

24 Colo. Rev. Stat. § 39-22-344(1); Idaho Code § 63-3026B(3)(c).

25 NMSA 1978 § 7-3A-10(C).

26 N.J. Rev. Stat. § 54A:12-3(a); N.Y. Tax Law Art. 24-A § 860(h)(1).

27 S.C. Code Ann. § 12-6-545(G)(2).

28 Ariz. Rev. Stat. Ann. § 43-1014(A); Utah Code Ann. § 29-10-1402(19).

29 Ariz. Rev. Stat. Ann. § 43-1014(C).

30 Cal. Rev. & Tax. Cd. § 19900(a)(2); Cal. Rev. & Tax. Cd. § 17052.10(b)(3)(A).

31 L. 2023, S554 § 2(1); Montana Pass-Through Entity Tax, 06/12/2023.

32 L. 2021 Chapter 419 § 1; N.J. Rev. Stat. § 54:12-2.

33 S.C. Code Ann. § 12-6-545.

34 Cal. Rev. & Tax. Cd. § 17052.10(c).

35 Hawaii Tax Information Release No. 2023-03, 12/27/2023.

36 Mass. Gen. L. Ch. 63D § 2; Massachusetts Technical Information Release No. 22-6, 03/18/2022.

37 See, e.g., L. 2023 Act 50 § 2.(f); Hawaii Tax Information Release No. 2023-03, 12/27/2023; ILCS Ch. 35 § 5/201(p)(7); N.Y. Tax Law § 860(h)(1).

38 See e.g., Ark. Code Ann. § 26-51-404(b)(35)(A); La. Rev. Stat. Ann. § 47:297.14(a)(1); S.C. Code Ann. § 12-6-545(G)(3); Wis. Stat. § 71.21.

 

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