What are Pass Through Entity Taxes?

The passage of the 2017 Tax Cuts and Jobs Act instituted a limit on the State and Local Tax (SALT) deduction of $10,000.? As a workaround to receive more tax benefit for business owners in high tax states like California and New York whose deductions have been severely limited by this cap, many states have begun to implement pass through entity taxes (PTETs) as a tax planning workaround.?

How do Pass Through Entity Taxes Work??

The pass through entity tax allows a business owner of a pass through entity such as an S corporation or partnership to pay state tax payments directly through the business as opposed to having those taxes flow through to the owners individual returns.????

By paying these state tax payments through the business it creates a federal tax deduction for the business owner that, as a business deduction, is not subject to the $10,000 SALT deduction limit.?

?As it currently stands, 33 different states allow PTETs and the strategy was given the IRS’s blessing in IRS Notice 2020-75.?

The details of how PTETs work varies from state to state but in general the process is as follows:?

1. Business owner makes a PTET election, subjecting the business to the state level taxes and paid at the entity level.?
2. The business owner receives a tax credit on their personal state taxes to offset up to 100% of the state taxes paid by the business.? Some states offer a credit that is less than 100% meaning that some business income is effectively double-taxed.?
3. The state tax payment paid by the business is included as a deductible business expense on the business’s federal tax return, lowering its net income that is divided among each of its owners and passed through to their federal tax returns.?

Considerations for Pass Through Entity Taxes?

Many states tax pass through entities at a flat rate as opposed to the progressive rate that many states use to tax individuals.? This can lead to higher state taxes if the flat rate is higher than the blended progressive rate an individual might have been subject to.?

That said, for very high earners in some states like California the PTET rate can be lower than the top individual tax rate and lead to a reduction in state taxes.?

Example: Dave is the sole owner of a law firm in California with $333,333 of net income.? A PTET election would result in a 9.3% flat tax on that amount or $31,000.? As a single filer, this is $3,730 than what Dave would owe individually on that income.? With the PTET election, he is able to deduct the $31,000 from his federal taxes resulting in $21,000 in additional deductions assuming no other deductions.? At the 32% federal tax bracket, this amounts to $6,720 in additional federal income tax savings.?

?Unlike the SALT deduction, as a deductible business expense a PTET is an above the line deduction that can lower a taxpayers individual AGI.? This is notable because many deductions, credits, and tax thresholds – including the Roth IRA contribution limit and net investment income tax thresholds – are based on an individual’s AGI.? As a business owner, retirement plan contributions, self-employment taxes, additional Medicare tax, and QBI deduction amounts can be reduced by the PTET election as well.?

Finally, because the PTET election takes what would be an itemized tax deduction and makes some or all of it a deductible business expense instead, an individual’s itemized deduction totals can be impacted and potentially reduced.?

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Disclosure: Any opinions are those of Michael Dunham, CFP? and not necessarily those of Raymond James.? This material is being provided for informational purposes only and is not a complete description, nor is it a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance is not indicative of future results.?

?While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.