The landscape for state pass-through entity taxes continues to change. More states have enacted laws to provide an election for pass-through entities to pay tax at the entity level so owners can claim additional state and local tax deductions that may exceed the $10,000 federal cap. However, the states aren’t consistent when it comes to making the PTET election, and rules may differ depending on the type of PTE.
Partnership and S corporation owners need to reflect on unique compliance considerations that could affect the value the PTET deduction provides. If the rules aren’t fully understood, individual owners may not receive the benefit of the PTET deduction or, worst case, may increase their total state tax liabilities.
PTET Election Timing and Eligibility
The timing of a PTET election is critical. If the entity doesn’t make an M&A transaction, the PTET election could significantly reduce the seller’s federal taxes on the gain while reducing the amount a buyer pays where a gross-up payment is negotiated. If an election isn’t timely, that failure could result in the loss of tax savings that may have been factored into the transaction price.
Also, the ability to make a PTET election may be limited if the PTE ownership contains a broad mix of individuals, corporations, and upper-tier PTEs. Many states exclude certain members’ income from the tax base and may not allow the PTE to make the election if owned by ineligible members. For both parties to get the most favorable result, buyers and sellers should discuss with counsel the best structure to ensure the full PTE benefit is received.
How Does a PTET Election Affect Estimated Taxes?
The impact of estimates on the entity and its owners varies based on the state in which the PTET election is made. In some states, failing to make timely payment of estimated PTE taxes throughout the year could disqualify the PTE from the election. Depending on the state, a PTE may have decided that a PTET election is the right course of action, then find out it’s disqualified from making the election because it didn’t pay estimates throughout the year or by the date required. Also, many states haven’t defined what percentage of the PTET due at the end of the year would constitute a safe harbor for avoiding penalties and interest for underpayment of estimates, so additional amounts may be due.
Many owners may not need to pay additional estimates or nonresident withholding to the states in which a PTET election is made. The election itself may cover their entire liability and could make the owner eligible to receive a refund. In other states, the PTE owner may need to make additional estimates when the amount paid by the PTE doesn’t cover all income taxable by the state.
Communication and coordination between owners and their PTE are essential in properly navigating state tax estimates.
Do Special Allocations Affect Owner Deductions?
In short, yes. Consider guaranteed payments and expense allocations. Some states may include guaranteed payments in the PTET base. But consider a partnership where, under the agreement, one partner recognizes a special allocation of 100% of expenses while other partners receive guaranteed payments in which a PTET tax deduction is created. Partners with guaranteed payment income wouldn’t receive the PTET deduction from ordinary income due to the special expense allocation provisions.
To avoid these situations, the partnership agreement may need to be amended to create specific carve-outs that address allocating income, losses, deductions, credits, and similar PTET items to the partners.
GAAP Rules and PTET Elections
Differences in state approaches to the PTET election can cause differences between book and taxable income of the PTE and its owners. It’s important to understand whether the state’s PTET constitutes an expense borne by the entity or a payment on behalf of the owners. IRS rules say that if the PTE election results in tax at the entity level, it creates a valid deduction that can be reduced from the income distributed to owners.
GAAP looks at it differently, asking who ultimately holds the liability for the payment of tax. In some states, the tax is levied at the entity level, but if the entity doesn’t pay, the liability becomes the responsibility of the individual owners. In that circumstance, it arguably is not a responsibility of the company for GAAP purposes and would be treated as a distribution. That creates a mismatch between GAAP and tax accounting, a permanent difference that needs to be analyzed and tracked annually.
Partnerships, S corporations, and the individuals who own them should consider the benefits of a PTET election, but everyone involved should understand that it’s a complicated computation and should ask:
- What are the timing requirements for making the PTET election, and can we meet those requirements to fully realize the benefits?
- How does the PTET affect the income allocated to our owners?
- How does this election affect our estimates, and have we considered the state-specific requirements for payment of estimated tax?
- Are we prepared to analyze and track annual GAAP and tax accounting mismatches?
Taxpayers considering a PTET election should contact their tax adviser to discuss the potential benefits and fully understand the nuances before committing to making PTET elections.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
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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