Since the passage of the Tax Cuts and Jobs Act (TCJA), taxpayers have faced new restrictions on deducting state and local taxes (SALT) including a $10,000 cap.
Those in higher-taxed states such as New York or California especially feel the impact of this limit.
Currently, taxpayers are limited to deducting a total of $10,000 annually. This amount applies to both single filers and married couples filing a joint tax return (for married couples filing separate tax returns, each spouse can deduct up to $5,000 in SALT).
There have been discussions in Congress on raising the SALT deduction cap, at least temporarily. However, negotiations have stalled, and there’s considerable uncertainty about whether a change in the SALT deduction will materialize.
The limit has also impacted certain business owners who report business income on their individual tax return. And in recent years, many states have pursued a legislative solution.
States respond with new laws
Most businesses are structured as pass-through entities (S-Corps, partnerships, and LLCs) meaning that net income generated from the business is eventually reported on the individual tax return. Owners or partners of these businesses feel the impact of the $10,000 cap on deducting SALT.
As a result, many states are taking measures that effectively allow certain business owners to bypass the $10,000 SALT cap when filing their federal income tax returns.
Roughly 20 states acted to implement new pass-through entity (PTE) taxes, which generally allow business owners/partners to elect to pay state income taxes at the entity level as a means of avoiding the SALT cap.
The payment of the PTE tax by the business entity reduces the amount of business income that flows through and is subsequently reported on the federal income tax return. This results in less income subject to taxation. These types of new state laws have accelerated since the IRS issued Notice 2020-75 in 2020, which provides guidance that entity level tax payments imposed by states are deductible for federal income tax purposes.
PTE legislation is pending in Iowa, New Mexico, Pennsylvania, and Virginia.
Sources: Tax Foundation, Tax Policy Center, Bloomberg Tax, CNBC.
PTE tax rules vary by state
- In most states the choice to pay a state PTE tax is elective. Connecticut is the exception, where the tax is mandatory
- Generally, upon paying the state PTE tax the business owner will receive a tax credit for their share of distributable income on their individual state tax return. This is to ensure they are not double-taxed at the state level — once as a business owner, and another time as an individual
- The amount and structure of tax credits provided to avoid duplicate payment of state income tax will vary as will the filing requirements and deadlines
- In many states, businesses without employees, such as single member LLCs, are not eligible to elect to pay a PTE tax
- In cases with multiple owners/partners, some states will allow each individual to elect whether or not to opt in to the state PTE tax, without requiring all business owners/partners to elect to pay the tax
Opting in requires careful consideration
Given the complex nature, and variability, of these PTE tax structures, the decision to opt in to a state PTE tax requires careful analysis and consideration based on individual circumstances. In some cases — such as a business owner who is not a resident of the state where the PTE tax applies — electing to pay a PTE tax may not make sense.
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