Skip to main content

Could Your Practice Benefit from Electing a State Pass-Through Entity Tax?

As most readers are certainly aware, the Tax Cuts and Jobs Act (TCJA), passed in late 2017, imposed a $10,000 limitation on the State and Local Tax (SALT) deduction for individuals who itemize their deductions on their federal income tax return. The SALT cap applies under current law through December 31, 2025. This drastically limited the ability of taxpayers in states with state income taxes to take Federal deductions, but also limited many individuals who pay high state and local property taxes from fully deducting these expenses.  The TCJA did not impose any similar cap on state and local taxes incurred and paid by businesses.

In response, many states have added an elective pass-through entity (PTE) tax which allows partnerships and S corporations to elect to be taxed at the entity level for state income tax purposes. Partners and shareholders of entities that elect to pay this tax are then generally allowed to either claim a credit on their individual state income tax return or exclude their distributive share of pass-through income from their personal state income tax return. Since the business can deduct state income taxes from its Federal tax return, the shareholder or partner’s Federal pass-through income is reduced, effectively allowing the owner to receive a Federal tax deduction for state income taxes paid on his or her business income.

While only 16 states had pass-through entity taxes prior to 2022, another twelve states have added this option in 2022- and Missouri has added it to become effective in 2023. In addition, three more states (Iowa, Pennsylvania, and Vermont) have legislation pending. When one considers that nine states have no owner level personal income tax, this leaves only nine states that have not yet proposed or enacted PTE taxes. States that have not yet proposed or enacted as of the writing of this article include Delaware, Hawaii, Indiana, Kentucky, Maine, Montana, Nebraska, North Dakota, and West Virginia. Connecticut is the only states that makes the PTE tax mandatory.

In determining whether an election to be subject to your state’s PTE tax is right for your practice, first and foremost consult with your CPA. Several factors will need to be considered in making this decision. The timing of the election is important, along with the need for estimated tax payments. Some states have determined that they will not impose underpayment penalties for estimated payments not timely made on a new PTE election. The practice must also consider whether the election impacts all owners or only a portion of owners.

For example, if some owners live in states with no state income tax and have only a minimal or no tax due in the state where the election would be made, a PTE election would have a negative impact on those owners. It is also important to understand whether your state’s election is an annual election or whether it is binding for future years. These analyses can be done by your CPA who will be familiar with your state’s laws and the impact it will have on the owners of your practice.

In some states, only entities with individual owners can make the election. Therefore, if an owner owns his interest through an individual entity, the election may not be available for the practice.  Some states allow for an owner-by-owner election to participate, thus individual owners can determine whether the election is beneficial to them. If not all shareholders participate, there needs to be consideration for S corporation owners to determine that distributions are not disproportionate. While the IRS has not yet issued guidance on this, the AICPA has recommended that PTE tax payments follow composite payment deemed distribution treatment.

Perhaps the best news about the PTE tax solution is that the IRS essentially blessed this workaround to the SALT cap in Notice 2020-75. In this Notice, the IRS clarified that partnerships and S corporations can deduct state and local tax payments at the entity level for Federal purposes in computing taxable income or loss.

There are many nuances for businesses and medical practices to consider with each state’s particular PTE tax election. Practices that have tax liability in multiple states will have further items to consider. Most importantly, we encourage physicians to work with their CPAs and advisors to determine the rules in their states and how a PTE tax election would impact practice owners. In some states, the election is still available for 2022 taxes. Act now to see if this is a workaround to the current $10,000 SALT deduction limitation that may be available to you and your practice

Be sure to read the other articles featured in our October 2022 newsletter: