Who Should Pay State Income Taxes on Pass-through Entity Income?

March 7, 2022This year, it could be beneficial for pass-through entities such as S corporations and partnerships (often formed as limited liability companies – LLCs) to pay their own state income taxes instead of having their owners pay them as they normally do.

As the name suggests, pass-through entities (PTEs) pass along the income they realize to their owners to report on their tax returns. The owners then pay income taxes on the company’s income.

The problem
The Tax Cuts and Jobs Act implemented a maximum amount of state and local taxes that an individual can deduct when itemizing – $10,000 ($5,000 for married individuals filing separately). This limit is effective for the years 2018 through 2025. This deduction cap is imposed on the combined total of state and local income taxes, real and personal property taxes, and certain other taxes.

This was not a welcome law change, as many individuals lost the ability to deduct substantial amounts of these taxes that they incurred. Arguably, those hit hardest by this limitation were PTE owners, who often pick up thousands and even millions of dollars of income from their businesses. Taxpaying entities like C corporations don’t have this limitation. Many states started considering ways to provide their residents with a workaround.

A solution
In November 2020, the IRS issued a notice that effectively provided a roadmap for states to enact legislation facilitating such a workaround for income taxes triggered by PTEs. The notice indicated that Treasury and the IRS would issue proposed regulations on this topic, although those regulations have not been released yet. In a nutshell, the notice provides that state and local income taxes assessed on and paid by a PTE on its trade or business income are deductible by the PTE and thus not subject to the $10,000 cap.

States recognized that this presented them with an opportunity. Instead of having owners pay income tax on their share of PTE income, they could allow PTEs to elect to be assessed the tax themselves. While the income would still pass through to the owners, the owners would be allowed a corresponding offset to avoid paying tax that the PTE had already paid. The net result would be having state and local income taxes fully deductible on the PTE’s federal tax return.

State action
At this point, 22 states have enacted legislation to allow PTEs to make such an election, including North Carolina, South Carolina, and Georgia. In addition, several states such as Virginia, Pennsylvania and Ohio have proposed legislation that would allow PTEs to make this election. Some states made this election available for the 2021 tax year, while others like North Carolina made it effective starting with the 2022 tax year. Most states have opted to have the election made with the PTE’s tax return, while others allow it to be made in advance.

Should an election be made?
A careful analysis should be done to determine the implications and potential benefits of making such an election. Following are some of the key considerations:

• Only some types of business income may be eligible for this workaround. Specifically, it may only apply to “trade or business” income, typically reported on page 1 of S corporation and partnership income tax returns. For example, capital gains and income from rental real estate may not qualify.
  
  
• State laws vary on several points, including when and how to make the election, how to claim credits for income taxes paid to other states, and whether the PTE is subject to estimated income tax obligations. Some states also don’t recognize pass-through status and assess the tax to the entity, in which case such an election is not necessary.
  
  
• The state and local tax deduction limitation only applies to individual taxpayers. If a PTE has owners other than individuals (e.g. trusts) and those owners bear some of the tax burden, the election may not be as advantageous.
  
  
• The PTE’s overall accounting method used for tax purposes (cash or accrual basis) could play a role in which year the taxes can be deducted. Also, the election can be considered each year.

Making upcoming tax payments
PTE tax returns for 2021 are coming due (typically March 15 or April 18), and individual tax returns are due April 18. In addition, 2022’s first quarterly estimated tax payments are due April 18. Who should make the state income tax payments?

For PTEs filing in states that enacted this workaround legislation effective for the 2021 tax year, consideration should be given to the availability and impact of this election on tax payments that are due with the tax return or an extension.

For PTEs filing in states like North Carolina who can first make this election with their 2022 tax return, consideration should be given to who will pay estimated tax payments that are due soon, the PTE or its owners.

We recommend that you discuss these rules and the associated considerations with your tax advisor.

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