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Pass-Through Entity Tax Has Had Unexpected Consequences

Sarah Kim, Principal, Citrin Cooperman Advisors LLC / Berdon Advisors LLC

12.06.21 | SALT Chat

Looking back on 2021, I would say the most noteworthy development of the year in state and local tax was the pass-through entity tax (“PTET”). The Tax Cuts and Jobs Act, enacted in 2017, imposed a $10,000 state and local tax deduction cap on individuals. Several states responded by adopting the PTET as a way to mitigate its adverse impact on individual owners of pass-through entities. In November 2020, the IRS issued guidance approving the federal treatment of deducting pass-through entity taxes that were paid by the entity and flowed through to their owners as income tax credits. With this approval, in 2021, more than ten states adopted the PTET, including California and New York, whose PTET legislation became effective for tax year 2021. Currently, there are more than 20 states with a form of PTET and the legislation is pending in a couple of states (e.g., Ohio, Pennsylvania).

The Unexpected

It was anticipated that many eligible businesses would opt into these workarounds. But this was not the case.  For example, in New York, only about 10% of eligible businesses opted into the tax for the initial year. The fact that state tax authorities (regardless of adoption of its own PTET) have not provided clear and sufficient guidance on this tax likely contributed to the low participation rate. One of the concerns of electing into the tax is the risk of double taxation for nonresident partners. For example, if you are not a New York resident partner of a partnership that elected into the NY PTET, your home state may not allow you to claim a credit for the NY PTET paid against your resident state income tax liability. So for multistate entities with owners spread across multiple states, the decision is not a simple one to make.

There are other considerations relating to the rules and mechanics of various pass-through entity taxes and the complexity around the interplay with other state taxes (e.g., owners cashflow, nonresidents withholding, composite return credit/filing, tiered structure credit, compliance costs, etc.).

The limitation is currently set to expire at the end of 2025. The House-passed version of Biden’s economic bill would lift the limitation to $80,000 and extend it through 2031 (It would go back to $10,000 in 2031 and then expire in 2032). The Senate is negotiating over setting a certain income cap on those who can receive the deduction and phasing out the deduction above the income threshold. It is unclear how the final bill would read and what impact the bill would have on state PTET regime. Stay tuned for further development in this area.

If you have questions, please feel free to contact me at 646.346.6467 | skim@berdon.com or reach out to your Berdon tax advisor.

Sarah S. Kim is a Senior Tax Manager in Berdon’s State and Local Tax Group with nearly ten years of professional experience. Sarah advises Fortune 500 and middle-market businesses across an array of industries. She has experience with various types of taxes, including corporate income and franchise tax, sales and use tax, personal income tax, unincorporated business tax, commercial rent tax, and real estate transfer tax.

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