By: Gary Hirsh, CPA, CFP®
The "Tax Cuts and Jobs Act" (TCJA) of 2017 brought a significant shift in the taxation landscape for individuals and businesses. One of the changes was the $10,000 cap on deductions for state and local taxes (SALT). This limit impacted the tax strategy of many high-tax states, pushing them to find ways to mitigate the impact of this cap on their taxpayers.
In response, some states introduced "pass-through entity" (PTE) taxes.
What is a Pass-through Entity Tax?
A pass-through entity is a business structure where the business income is passed through to the owners' individual tax returns and taxed at individual income tax rates. This includes structures like partnerships and S-corporations.
The 2017 TCJA imposed a limit on SALT deductions for individuals, but businesses had no such limitations. Therefore, by introducing PTE taxes, states essentially converted the non-deductible personal state and local taxes into deductible business expenses, at least for those business owners operating under the pass-through entity structure. These PTE taxes are also called "specified income tax payments."
An IRS ruling confirmed the legality of this workaround; however, it left it to the states to determine their eligibility requirements and election procedures. As a result, each state has its own nuances regarding these PTE taxes.
One key question remains whether investment income (like dividends, capital gains, and interest) can be treated similarly. As of now, no proposed regulations have been published regarding this.
It's important to note that this tax strategy only works for businesses set up as pass-through entities. Sole proprietorships cannot utilize this tax strategy, where income is reported on Schedule C for Form 1040.
Currently, Connecticut is the only state to impose a mandatory PTE tax. Other states have different rules. For example, Massachusetts only allows 90% of the tax paid by the entity as a credit on its individual return. Rules can also differ based on whether the shareholders or partners are residents or non-residents of the state.
In short, using PTE taxes has become a strategy to mitigate the impact of the SALT deduction cap introduced by the 2017 TCJA. While it offers a potential workaround for some business owners, it also introduces a new layer of complexity to the already intricate field of tax law. The rules and potential benefits can vary widely by state and the specifics of an individual's or entity's income situation, so consultation with a tax professional is highly recommended.