This article was originally published on Dec. 17, 2020 and has been updated.
The term “panacea” is named for the Greek goddess of health or remedy, a “cure-all” to poor health. Taxpayers are often looking to achieve the best result for their circumstances in the most efficient manner possible. In practice, however, there is rarely a single strategy to cure-all without some balance. The complexity of state taxes magnifies this balance, for example, attempting to reduce income taxes in one jurisdiction may result in higher states taxes in another jurisdiction or an increase in burdensome compliance. Taxpayers must understand their circumstances and model out the best result – it’s not always clear on the surface.
With the proliferation of state proposals for pass-through entity workarounds, a federal notice providing support for the states’ approach, and the eagerness to reduce the impact of the $10,000 SALT deduction limitation, pass-through entities may be considering electing into workarounds under the assumption that there will be an ultimate state or federal tax savings. However, many pass-through entities are discovering that’s not the case.
Background
On Nov. 9, 2020, the IRS issued a notice announcing its plan to propose regulations that confirm certain pass-through entities are not subject to the $10,000 state and local tax deduction limitation imposed by the Tax Cuts and Jobs Act (TCJA, P.L. 115-97).
Recall that the TCJA limited the individual taxpayer deduction for state and local tax (SALT) payments to $10,000 a year ($5,000 for a married person filing a separate return). SALT payments (including income and real property taxes) that exceed these amounts are no longer deductible by individual taxpayers unless the payments are in pursuit of a trade or business.
As a response to that limitation, several states adopted a pass-through entity-level tax intended as a workaround. The intended benefit of the pass-through entity paying the tax is that the ultimate partner can re-characterize a non-deductible individual state income tax expense to a deductible state income tax expense for federal income tax purposes. The taxes paid by the pass-through entity are deductible for federal income tax purposes, where the SALT limitation would apply if that tax was passed through to the member. Until the recent notice, it was unclear whether the deduction would be permitted at the federal level.
As of the date of this article, twenty states have enacted workarounds (with the first effective year in parentheses) include Alabama (2021), Arizona (2022), Arkansas (2022), California (2021), Colorado (2022), Connecticut (2018 and mandatory), Georgia (2022), Idaho (2021), Illinois (2021), Louisiana (2019), Maryland (2020), Massachusetts (2021), Minnesota (2021), New Jersey (2020), New York (2021), Oklahoma (2019), Oregon (2022), Rhode Island (2019), South Carolina (2021) and Wisconsin (2018). A workaround was vetoed in Michigan, but the recent budget signed by the governor provides for costs associated with administering the tax, suggesting that the legislature intends to override the veto or pass another version of a workaround. Limitation workarounds have generally been provided on an elective basis, except in Connecticut where the tax is mandatory.
Is there a benefit?
Importantly, not all pass-through entity members will benefit from electing into a state workaround. In larger multi-state pass-through entities, only a few members may benefit at the expense of others. For example, nonresident owners may not be able to receive a state tax credit in their resident state for taxes paid by the pass-through entity, resulting in a higher state tax liability for certain owners. Just as some states prohibit a state income tax credit for Texas franchise tax, some states may similarly deny a credit for a member’s pass-through entity tax paid in another state.
While the credit for taxes paid issue is one of the most noteworthy, there are many other considerations for pass-through entities. In some cases, the pass-through entity tax rate may be higher than the individual rate, as is the case in Wisconsin, and depending on each member’s tax profile, the election may be detrimental. Additionally, not all credits and deduction normally available to partners individually will be available at the entity level.
The following are other considerations to note:
- Do all pass-through entities qualify?
- Must all members agree in order to elect into the tax?
- Will all members benefit from electing into the pass-through entity tax?
- When can an election be made or revoked? Can the entity make a retroactive election?
- How is the taxable base calculated? Guaranteed payments and other allocations may also be included in the taxable base.
- Sourcing rules may be different for the entity versus the individual member. These differences may have a significant impact for some taxpayers.
- How are tax-exempt foreign members treated?
- Can corporate members receive a credit for tax paid?
- How does a pass-through entity treat net operating losses?
- Is depreciation from basis step-up adjustments deductible at the entity level?
- Is the amount paid by the entity fully creditable or excluded in the same state for the member?
- Are there ASC 740 concerns with the entity-level tax?
- Will maximizing the benefit require the entity to adjust its legal or operating documents?
- Are there other administrative complexities that may outweigh the ultimate savings?
- Is a full credit of the tax paid by the entity available for individual tax purposes? (the elective tax in Massachusetts provides a 90% credit)
There may be other tax considerations that make the election undesirable. In some states, even the form of the pass-through entity matters. In Maryland for example, nonresident shareholders of S corporations are unlikely to benefit from an election. Accordingly, understanding whether a pass-through entity election results in a benefit requires modeling and detailed analysis of all the risks and opportunities involved. Especially in large, multi-state partnerships, a workaround election may provide tax savings for select members, while increasing tax on other members, thus producing an unintended result. A pass-through entity must conduct thorough due diligence to understand how and whether the workaround election is ultimately beneficial.
Takeaways
Over 12 workarounds were enacted in 2021, a clear increase from recent years. Other states proposed on workarounds and will likely do so again in 2022. However, federal tax reform proposals to temporary repeal or raise the limitation may impact how some pass-through entities proceed.
In contemplating whether to make the election, pass-through entities, especially large, multi-state entities, should be aware that the aggregate additional state tax burdens might exceed the federal tax savings. Pass-through entities must carefully consider whether the election will benefit the members’ federal and state tax profiles.
