The Benefits of the Pass-Through Entity Tax
The Tax Cuts and Jobs Act (TCJA) was enacted in 2017 and effective January 1, 2018. This brought with it many tax changes.
Most of these changes were beneficial to businesses such as the decrease in tax rates along with the Qualified Business Income Deduction. There were also some changes, though, that increased taxes such as the interest expense limitation for businesses and the $10,000 state and local tax (SALT) deduction limitation for individuals. This article addresses the $10,000 SALT deduction limitation.
When looking at a C Corporation, the business pays its own federal and state taxes. Because of this, the C Corporation can deduct on its federal return all the state tax expenses it pays. Pass-through entities that are being taxed as an S Corporation or Partnership, generally do not pay federal and state income taxes. These are borne by the individual shareholders and partners. The state income taxes paid by these individuals are then deducted on the individual’s income tax returns. Before the TCJA, this usually was not an issue as the owners could generally deduct all of their state taxes on their individual income tax return as long as they itemized their deductions on Schedule A. Since the TCJA limited the state and local tax deduction to $10,000, there were large amounts of state taxes that were being paid without the benefit of a federal income tax deduction. This adversely effected individuals that worked in areas that had high state income and property tax rates.
In response to this, Connecticut imposed a tax at the pass-through entity (PTE) level which effectively allowed the entity to take a state tax deduction on its federal business return. This, in turn, moved the state tax deduction from Schedule A (where it was limited to $10,000) to Schedule E (where there are no limitations). Even though other states noticed this was an effective way to maneuver its taxes around the $10,000 itemized SALT limit, only a few followed suit as they were unsure if the new tax structure would stand in court.
Two years after Connecticut imposed its pass-through entity tax in 2018, the Internal Revenue Service issued Notice 2020-75, which effectively announced states could enact the state tax as Connecticut had done. Once this notice was released, more and more states started changing their tax code to allow for this deduction at the entity level.
From obtaining authorization from the owners to having to pay estimated taxes, each state has their own quirks with what must be done in order to qualify for this tax treatment. If you are looking to see if you qualify for this PTE tax or if you have any other tax questions, contact your DSWD trusted advisor.