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Choice Matters With Pass-Through Entity Income Tax Elections

Oct. 18, 2022, 8:45 AM

A majority of states enacted pass-through entity tax laws, allowing partnerships and S corporations to elect to pay state income taxes at the entity level that are deducted from federal taxable income earned by pass-through entity owners. Depending on whether the PTE is a partnership or S corporation, a PTET statute could provide a greater tax benefit.

State statutes aren’t always consistent when determining the tax base for resident and nonresident owners, and they may differ further when it comes to what owners are eligible to receive PTET deduction benefits.

Due to the varying rules imposed by the states, there could be significant tax consequences at both the federal and state level, depending on the residency of the PTE owners combined with language contained within the PTE’s legal documents.

Invalidation of a Federal S Corporation Election

S corporations require income, deductions, and distributions to be based on the pro rata share of ownership. If the IRS finds that income and deductions haven’t been pro rata, the agency could invalidate the S election and the entity would revert to a taxable C corporation. Therefore, before making a PTET election, S corporation shareholders need to understand how the deduction will impact their income and deductions.

In some states, a PTET election can have a non-pro rata impact among S corporation owners, particularly if the ownership group includes individuals who are residents of different states or where owners are not included in the PTET filing. So it’s possible that a PTET election could inadvertently invalidate the federal S election, causing it to lose PTE status and the ability to make a PTET election. An invalid S election creates a host of other complications for federal and state taxes beside the PTET eligibility.

These consequences can be avoided with careful planning and documentation of distributions to owners and payments that shareholders make back to the corporation. Partnerships, on the other hand, won’t lose PTE status because partnerships aren’t required to allocate income, deductions, and distributions on the pro rata share of ownership.

State Apportionment Impact on PTE Benefits

In general, if a PTE operates only in one state, the type of PTE won’t significantly impact the benefits that owners receive, because 100% of the income would be included in the PTET base. But if a PTE is taxable in multiple states, it’s possible that the full benefit of the PTET deduction may not be received. State rules vary significantly when it comes to determining the tax base in which the PTET applies.

For S corporations, some states only include income in the tax base to the extent it was derived from activity performed in the state. In this case, a resident owner’s entire state tax liability wouldn’t be covered by the PTET deducted. Here, the resident owner would be taxed on 100% of their distributable income on their individual return, where the PTE only paid tax on the amount apportioned to the state. Other states will look to residency of the PTE owners. For PTE owners who are residents, the tax base would include 100% of their income. For nonresidents, the tax base would only include the income apportioned to the state.

S corporation rules require income and expense items to be allocated to shareholders on a pro rata basis. Due to this requirement, some state statutes will result in shareholders receiving federal deductions on the income earned by other owners. This is because of the differing rules when it comes to apportioning or allocating income for nonresident and resident owners. PTE benefits also could be impacted for partnerships, depending on whether there are special allocations for the allocation of income and expenses to partners.

Who Owns the PTE?

The PTET election was created by states to give individuals a way to deduct state income taxes from their federal income. The election and reporting are less complex when made by a partnership or S corporation owned entirely by individuals. However, many partnerships have ownership groups that include other PTEs, C corporations, and trusts.

In some states, the existence of PTE or C corporation owners can make the PTE ineligible to make the PTET election. In states where multi-tier PTEs are permitted, the allocation of the PTET benefit and tax base becomes more complicated because PTET paid needs to flow through to the ultimate individual or corporate owner. This information is often unknown, and the ultimate owner may not be eligible to claim the PTE deduction or related credit.

Who Makes the PTET Election?

Partners and shareholders may be negatively impacted if they are bound to the election, and steps may need to be taken to make these PTE owners whole. The rules vary when it comes to making the election, and not all states require all or a majority of PTE owners to agree to the election for it to apply.

Partnership agreements and other legal documents may need to be amended to address the inconsistencies in state law. Separate provisions in the agreements may need to be drafted that specifically speak to the allocation of the PTET deduction among owners.

Key Takeaways

When a PTE is considering a PTET election, or a new venture is looking for insight on entity choice based on PTET options, the decision requires careful analysis of numerous factors. Make sure those involved in the decision consider:

  • Ensuring an S corporation election won’t be invalidated by making the PTET election.
  • How state apportionment rules may affect the benefits of a PTET election.
  • Who owns the PTE, as some states won’t allow certain owners to make a PTET election.
  • Who needs to be involved to make the PTET election.

If you have questions about the impact of a PTET election—either in your role as an executive at a pass-through entity or as an owner of one—please contact your tax adviser to discuss the specific facts and circumstances of your situation.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Tony Israels leads Plante Moran’s national tax office’s state and local tax due diligence group. He has clients in manufacturing, the service industries, and private equity.

Jason Parish is a partner at Plante Moran’s state and local tax group. He works in all areas of SALT, including income/franchise, sales/use, and gross receipt taxes, primarily in the service and manufacturing and distribution industries.

Ron Cook is the national practice leader of Plante Moran’s state and local tax group. He helps clients stay current on tax matters that impact their business and navigate the complexities of state and local taxes.

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