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PTE Credits and Composite Tax for Business Owners

The Pass-Through Entity Elective Tax Payment Credit is a tax credit introduced at the state level in response to the Tax Cuts and Jobs Act (TCJA) of 2017 in the United States.

 

The Pass-Through Entity Elective Tax Payment Credit is a tax credit introduced at the state level in response to the Tax Cuts and Jobs Act (TCJA) of 2017 in the United States. This credit was created to help offset the impact of the $10,000 cap on state and local tax (SALT) deductions via Schedule A for individual taxpayers.

 

The Pass-Through Entity Elective Tax Payment credit generally works as follows:

 

Eligibility: This credit is available to owners of pass-through entities (such as partnerships, LLCs, and S corporations) in certain states that have implemented a Pass-Through Entity Tax (PTET). A PTET is a state-level tax on the entity’s income rather than on the individual owners’ income.

 

Payment of PTET: The pass-through entity pays the state-level tax on its income, which is typically based on the entity’s distributive share of income allocated to each owner.

 

Credit for owners: Owners of the pass-through entity may be eligible to claim a credit on their individual income tax returns for the state-level taxes paid by the entity. This credit helps reduce their state income tax liability.

 

Deduction for owners: The benefit comes in the form of the deduction which the pass-through entity will be able to take in full on the books.  This deduction then gets passed through to the respective owner’s individual federal return and is therefore not limited on Schedule A to the SALT cap under the TCJA rules.

 

Alternatively, a composite state tax is a method where a single entity, usually a pass-through entity like an S Corporation or a partnership, pays tax on behalf of its non-resident owners or partners. This is commonly used in states with income taxes.

 

States with a PTET Election

 

Several states have adopted a PTET, each with its own set of rules and implications for businesses operating within their jurisdictions. Currently, thirty-six states and one locality (New York City) allow pass-through entities to elect to pay income tax at the entity level rather than the partner or shareholder level. Among the states that impose personal income tax on income flowing through to partners or shareholders, Maine, Pennsylvania, and Vermont have pending legislation that would enact an elective pass-through entity tax credit, while Delaware, DC, and North Dakota have yet to pass PTET legislation.

 

The opportunities and risks inherent in states’ PTET laws vary widely. It is important to assess each state’s rules individually.  Generally, entities treated as partnerships or S corporations for federal tax purposes can make the election, but there may be limitations or exceptions in some states. Additionally, while most states have enacted the elective tax indefinitely, several limit the election to years affected by the federal $10,000 SALT cap. The years applicable for the election and the ability to revoke it also vary from state to state.  Taxpayers should understand how to make the election, as methods and requirements differ from state to state.  Some states allow the election directly on the annual tax return, while others require a specific election form.  Calculation methods, sourcing rules, and tax rates for PTET also vary and are specifically defined by each state.  It is important to determine if the state mandates estimated tax payments that the entity must comply with. Pass-through entities, their owners and tax advisors should carefully weigh the benefits and implications for all owners prior to electing a state’s entity-level tax.  Ensuring a valid election is made and that it benefits the owners of the pass-through entities is key.

 

Refundable and Nonrefundable PTE States

 

One significant distinction among states with PTET is whether the tax paid by the entity is refundable or nonrefundable. In states with refundable PTET (e.g., Maryland, Virginia), the taxes paid by the entity can be refunded or credited to the individual owners’ state tax liabilities. This approach ensures that the owners receive the benefit of the tax paid by the entity, effectively reducing their overall state tax burden. For example, suppose a partnership operates in a state with a refundable PTET credit. The partnership pays $20,000 in state-level taxes.  If the owners collectively owe $15,000 in state income tax, they can use the $20,000 payment by the partnership to reduce their combined state tax liability and receive a refund of the remaining $5,000 ($20,000-$15,000). However, not all states allow for this treatment. In states with nonrefundable PTET credits, if the credit exceeds the owner’s tax liability, the excess may not be refunded. Therefore, it is important to check if a particular state’s credit is nonrefundable and, if so, whether the excess credit can be carried forward and for how long.  Understanding these rules is crucial for pass-through entities and their owners to effectively manage their state tax obligations.

 

Composite Taxes

 

Another option for pass-through business owners is filing a composite return. A composite return allows non-resident owners to elect to have the pass-through entity remit tax, generally at the top tax rate for individuals, for their portion of the business’ tax liability. The return is filed at the entity level on behalf of the owners electing composite filing. This election is optional to the business owners and must be confirmed in writing. The greatest benefit of the composite tax filing is that it avoids the owners’ requirement to file a non-resident state tax return at the individual level. The tax paid can also be claimed as an itemized deduction on the owner’s tax return on the federal level. However, due to the SALT cap taxes of $10,000, claiming the composite tax payment on Schedule A is most often not beneficial at the federal level. Additionally, since the taxes are withheld at the highest tax rate in the state, some owners may benefit from paying the entity taxes personally at a lower individual tax rate. At the state level, the composite tax payment can be included as an out-of-state tax credit on the owner’s resident state filing.

 

Conclusion

 

The PTET credit was introduced as a response to concerns about the limitation on SALT deductions under federal tax law. By allowing pass-through entities to pay taxes at the entity level and providing a corresponding credit to the owners, it aimed to mitigate the impact of the SALT deduction cap on certain taxpayers, particularly those in states with higher state and local taxes. However, the specifics and benefits of the credit can vary by state.

 

Alternatively composite state tax returns have been around for years with the purpose of easing the burden on individuals who must file in multiple state jurisdictions.   However, now that the PTET credit is an option, balancing the benefits of filing a composite return versus the potential tax savings of filing and paying PTET with respect to each individual owner’s state filing requirements is crucial.

 

It is important for taxpayers to consult with a qualified tax professional for guidance to determine which of these two types of pass-through entity state filings best suits their situation.

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