Executive summary: Kentucky and West Virginia are the latest states to adopt workarounds
Recently, Kentucky and West Virginia joined 31 other jurisdictions, including 30 states and one city, to adopt an elective pass-through entity level tax intended to help individuals circumvent the $10,000 limitation on the federal deduction for state and local taxes. Both states are permitting the election retroactively to 2022.
Kentucky and West Virginia enact pass-through entity workaround taxes
Kentucky pass-through entity tax
On March 24, 2023, Kentucky Gov. Andy Beshear signed House Bill 360 adopting an elective pass-through entity tax effective for tax years beginning on or after Jan. 1, 2022. The election must be made by the 15th day of the fourth month, or the 15th day of the 10th month upon the close of the taxable year if the return is extended. The election must be made by consent of the owners holding more than 50% of the ownership in the entity and is binding for that tax year. The tax is assessed at the Kentucky individual income tax rate, which for 2022, is 5.0%, and 4.5% for 2023.
Owners receive a nonrefundable credit of the pro rata share of the tax paid by the entity. A credit for taxes paid is allowed for resident taxpayers that are owners of pass-through entities doing business in other states when the tax is assessed and paid at the entity level.
A veto-proof majority of the legislature resoundingly passed the measure. Noteworthy, earlier drafts of the election called for a 95% credit to the individual owners. Only two states currently offer less than the full credit, Connecticut’s mandatory tax allows an 87.5% credit, and Massachusetts’ elective tax, a 90% credit.
West Virginia pass-through entity tax
On March 28, 2023, West Virginia Gov. Jim Justice signed Senate Bill 151 adopting an elective pass-through entity tax effective for tax years beginning on or after Jan. 1, 2022. Qualifying pass-through entities, entities that are not disregarded for federal purposes, may elect to pay the tax at the entity level on or before the due date for filing the return, including any valid extensions. The election is irrevocable for the tax year the election is made. The tax is imposed at the top marginal rate on individuals, or 6.5% for 2022 and 2023.
Owners are allowed a credit in the amount of the owner’s proportionate share of the tax paid by the entity. Excess credit may be carried forward for up to five taxable years. A credit for taxes paid in other states under similar provisions is allowed.
Kentucky and West Virginia join 31 other jurisdictions, 30 states and New York City, in adopting a pass-through entity election designed to blunt the impact of the federal state and local tax deduction limitation. A number of states have similar elections pending, including Hawaii, Iowa and Vermont. In previous years, pass-through entity election proposals have been introduced in Pennsylvania as well.
Both states will need time to develop administrative procedures in order to facilitate the new entity taxes. Taxpayers should also be aware that the retroactive nature of the tax could impact the deductibility for federal purposes. For more information on state pass-through entity elections generally, please consider reading our article on what you need to know for state pass-through entity tax elections and contacting your state and local tax adviser for more information.