How to Get a State Tax Deduction Post TCJA - The Passthrough Entity Level State Tax
The Tax Cuts and Jobs Act (TCJA) of 2017 introduced several major tax law reforms that impact many taxpayers. One of these major changes was the inception of what is commonly referred to as the SALT limitation, a limitation of deductible state and local taxes on individual income tax returns to $10,000. Prior to this limitation, there was no cap on the amount of state and local tax deduction itemizing taxpayers could claim on their individual returns. The Federal benefit available for paying state taxes lessened the impact of these state taxes on the taxpayer. The newly introduced limitation causes these state taxes to be in a sense more painful to those taxpayers who itemize rather than take the standard deduction, because now they are not getting as much of a Federal benefit.
State and IRS Response
In response to this limitation, many states immediately started looking for ways to soften the blow for their tax-paying constituents while not affecting the states’ overall revenues. Some workarounds have been struck down by the IRS while others have been approved. One such workaround for which the IRS has essentially given its blessing is the passthrough entity level state tax. IRS Notice 2020-75, issued near the end of 2020, expressed the Service’s intent to allow such a workaround and announced the Treasury Department’s plan to issue proposed regulations regarding the matter.
The overall concept of this particular workaround that many states have begun to adopt has three components. First, the state imposes an elective tax at the passthrough entity level. Second, the passthrough entity reduces its Federal taxable income by taking a state tax deduction. Third, the state gives a state tax credit at the partner or shareholder level. The overall result is that the individual receives a Federal benefit in the form of reduced Federal taxable income on their passthrough entity Schedule K-1, and in a beneficial scenario, they simply pay the state taxes they normally would have at the entity level rather than the individual level. As of the writing of this article, at least 23 states including California and Arizona have either enacted passthrough entity tax law or have proposed PTE legislation in the works.
California Assembly Bill 150
California Assembly Bill 150, recently approved by the Governor, contains legislation for this type of workaround. It is effective for years beginning on or after January 1, 2021 and before January 1, 2026. This workaround will be in effect until the earlier of December 1, 2026, or the repeal of the Federal SALT limitation, when the workaround would no longer be necessary. A qualified entity may make an election to pay an optional entity level tax and qualified electing partners are allocated a nonrefundable credit to use against their individual California tax liability. Only qualified entities may make the election. For California, a qualified entity is any partnership or S Corporation in which all partners/shareholders/members are either corporations, individuals, fiduciaries, estates, or trusts. Entities with a partnership or disregarded entity as a partner are not eligible. Publicly traded partnerships and entities permitted or required to be in a combined reporting group are also specifically excluded from eligibility.
A qualified nonrefundable credit is allocated to each partner/shareholder in the amount of 9.3% multiplied by the qualified taxpayer’s pro rata or distributive share of the qualified net income subject to the PTE tax. If the credit granted is larger than the taxpayer’s California tax liability for the year, the excess credit is carried forward for the following five years until it can be used. Note that in order for this election to be beneficial, enough California income at the individual level must be expected to utilize the nonrefundable credit. If an individual pays a California tax at the entity level and then is unable to offset income at the California individual return level, they have paid more California tax than needed and the Federal benefit received may not be worth the extra California tax paid. For taxpayers with large expected California tax liabilities, this election is almost sure to be beneficial.
California Election Requirements and Due Dates
The election must be made on an original, timely filed return for the taxable year of the election. For 2021, the total elective entity tax is due by March 15, 2022. For 2022 through 2025, an estimate of the greater of 50% of the elective tax paid the prior year or $1,000 is due by June 15 of the taxable year of the election. The rest of the elective tax calculated for the year is due by March 15 of the year after the taxable year of the election. The first June 15 estimate payment is necessary to make the election. If no June 15 payment is received, no election is allowed for the year.
Federal Tax Consequences
The California tax paid by the passthrough entity results in a Federal deduction for that entity, reducing the total taxable income allocable to the partners/shareholders. The question of how this deduction should be allocated amongst the partners is another unanswered question that will hopefully be acknowledged by promised proposed regulations. There are two options available: special allocation and pro rata allocation. Arguments for both sides exist, including that special allocation would match the state tax credit calculation, and that pro rata allocation would allow nonresident and resident California taxpayers to benefit equitably at the Federal level. Another uncertainty is related to the timing of the allowed Federal deduction. One interpretation of IRS Notice 2020-75 may indicate that the Treasury is planning on issuing regulations that will allow the deduction only for the taxable year in which the payment is made (cash method). For example, even though the California tax payment for the tax year 2021 may technically be due in March of 2022, it may be wise to make the payment before December 31, 2021 in order to take advantage of the deduction in the 2021 tax year. Another timing issue relates to accrual method partnerships and S corporations. If these entities are currently on the lag method, they may want to look into making an automatic accounting method change on Form 3115 if they wish to take the deduction sooner.
Arizona PTE Tax
Arizona also has enacted legislation regarding a state PTE tax. It is similar to California’s in concept, but there are a few notable differences. The Arizona PTE tax is available starting in 2022. The rate at which the credit and tax are calculated is 4.5%, lower than California’s 9.3%. Qualified partners/shareholders include individuals, estates, or trusts (no corporations), but having a partner/shareholder that is not a qualified partner does not preclude the entity from making the election (unlike California). The election may be made by the extended due date of the return rather than the un-extended due date required by California. For entities with income above certain thresholds, quarterly estimated payments are required.
The new California and Arizona state passthrough entity tax workarounds can be very beneficial, especially for taxpayers in high tax brackets who are partners or shareholders in small partnerships or S corporations. The Federal deduction will almost always be beneficial, as long as the state nonrefundable credit is usable. As always, we are happy to help in assessing your personal tax circumstances. Please contact our office if we can assist in any way.
AZ H.B. 2838 https://www.azleg.gov/legtext/55leg/1R/laws/0425.pdf
IRS Notice 2020-75 https://www.irs.gov/pub/irs-drop/n-20-75.pdf
AICPA. (2021). States with Adopted or Proposed Pass-Through Entity (PTE) Level Tax. AICPA. https://www.aicpa.org/content/dam/aicpa/advocacy/tax/downloadabledocuments/56175896-pte-map.pdf
California elective pass-through entity tax bill awaits governor's signature. (2021, July). Retrieved from pwc.com: https://www.pwc.com/us/en/services/tax/library/ca-elective-pass-through-entity-tax-bill-sent-to-governor.html
Election for qualified entity to pay individual income tax AB 150. (2021, July). Retrieved from Caltax.com: https://www.caltax.com/forums/topic/election-for-qualified-entity-to-pay-individual-income-tax-ab-150/
Five more states enact PTE tax elections legislation - AZ, CA, CO, MN, OR. (2021, August). Retrieved from bdo.com: https://www.bdo.com/insights/tax/state-and-local-tax/five-more-states-enact-pte-tax-elections
Rueben, K. S. (2021, June 24). State Pass-Through Entity Taxes Let Some Residents Avoid the SALT Cap at No Cost to The States. Retrieved from taxpolicycenter.org: https://www.taxpolicycenter.org/taxvox/state-pass-through-entity-taxes-let-some-residents-avoid-salt-cap-no-cost-states