Pass-Through Entity Taxes Present Five Main Stumbling Blocks

Pass-through entity tax rules continue to cause headaches. Nearly all states with an individual income tax have passed different PTET provisions, creating challenges for tax administrators and entity owners considering PTET elections. Five quirks have proven to be some of the most difficult areas to navigate.

PTET Election Timing

PTET election processes can vary by state. Many states require an election or payment to be made in 2023 for an election to be valid for the 2023 tax year. Although many states allow the PTET election to be made with the entity’s tax return, business and owners that haven’t planned for PTET during the tax year could trigger unintended consequences or may not qualify as having a valid PTET election.

Once a PTET election is made for the current year, most states hold that it’s irrevocable for that year. Some allow a pass-through entity to revoke the election prior to filing time.

Most states require all owners to participate in the PTET, whereas others allow individual owners to opt out. Many states require a participating pass-through entity to elect tax at the entity level each year, while some consider the election binding until revoked, or for a set number of years.

Filing Requirements for Nonresident Owners

Most states’ PTET rules don’t require nonresident owners of an electing pass-through entity to file an individual nonresident return if the owner doesn’t earn other income in the state. Notable exceptions are New York and California, which require a nonresident owner to file a nonresident individual income tax return, even if they’re an owner in an electing pass-through entity in the state.

Pass-through entity owners who typically file composite returns may find themselves subject to nonresident individual filing requirements in certain states. Electing pass-through entities must notify owners to prepare them for such filing requirements.

Rate Variations

In many states, one flat individual tax rate mirrors the PTET rate. But states with tiered tax rates can cause significant issues with the PTET, especially in California, where an individual doesn’t enter the highest tax bracket (13.3%) until they earn $1 million in state income.

Differences between a PTET rate and the individual’s true income tax rate affect all taxpayers. For high earners, a PTET credit may not cover all the individual’s state income, so estimated payments or withholding is still required, even though the PTET election and corresponding payments were made.

For modest earners, the PTET credit (received at 9.3% in California) may cover too much income relative to the individual’s state tax bracket. Also, in many states, including California, excess PTET credits aren’t refundable at the individual level and are carried forward.

Federal Returns

If an individual receives a refund related to state income taxes, federal rules may require that the refund is included in taxable income to the extent it was deducted as an itemized deduction. When an entity deducts state PTET and the owner receives a refund for excess PTET credits, it’s arguable that because the individual didn’t get an itemized deduction for the PTET, the refund isn’t required to be added to federal taxable income.

However, a federal concept known as the tax benefit rule holds that if an individual gets a benefit from a tax expense anywhere in the chain of ownership that leads to a refund, that refund should be included in income. This raises a question that the federal government hasn’t answered: When, if ever, is a refund of a PTET credit included in federal taxable income?

Differing Tiered Partnership Treatment

The complexity of the PTET rules for entities and owners significantly increases for tiered entities. PTET rules generally use one of three approaches for entities with entity owners:

Prohibition. Pass-through entities can’t elect PTET treatment if they have any owners that aren’t individuals, estates, or trusts.
Exclusion from income. The entity can elect PTET treatment if it has entity owners, but income attributable to entity owners is excluded from the calculation of pass-through entity taxable income.
Inclusion. A pass-through entity with other entity owners can elect PTET treatment, and income attributable to all owners is included in pass-through entity taxable income. When an entity owner is included with a PTET election, taxpayers will face challenges tracking the PTET credits related to lower-tier entities.

State rules for tiered partnerships vary greatly. Some states say no income—and thus, no credit—is passed up to an upper-tier entity if a PTET election is made. Other states say the income is passed up and the upper tier uses the credit.

Some states say the credit keeps flowing up until it’s used by an individual owner. Still, some states’ rules depend on whether the upper-tier entity itself is making a PTET election.

Communication between multiple entities is key when deciding whether, and at what level, to make a PTET election.

Outlook

One of the biggest obstacles PTE owners face is that there may be very little information provided about the elections made by the entity and the impact of those elections on their individual returns.

Still, Congress continues to make the state and local deduction limitation a negotiating point. Even broader change regarding the benefit of a PTET election may come. Working closely with a state and local professional can help taxpayers address these challenges.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

David Landwehr is a state and local tax manager at Plante Moran, focused on pass-through entities, sales tax, and state tax controversy.

Ron Cook is a state and local tax partner at Plante Moran and national practice leader of the firm’s state and local tax group.

Mike Merkel is a state and local tax partner at Plante Moran, providing clients with multistate tax consulting services and solutions to minimize sales and use, income and franchise, and property taxes.