Executive summary
On May 11, 2023, Gov. Kim Reynolds signed into law House File 352, providing for a pass-through entity (PTE) tax election retroactively effective for tax years beginning on or after Jan. 1, 2022. The tax will remain in effect as long as the federal government maintains the cap on the personal income tax deduction for state taxes under federal section 164(b)(6).
Iowa enacts pass-through entity tax election effective 2022
The election
The law establishes an annual PTE election for tax years beginning on and after Jan. 1, 2022. The tax is imposed on the entity at the highest graduated individual rate applicable for the tax year, which is 8.53% for 2022 and 6% for 2023. Under the law, partnerships and S corporations are eligible to make the election. The law allows a corresponding refundable income tax credit to the partner/shareholder for their share of any amount of tax paid by the entity on its Iowa-sourced income. Importantly, to account for the fact that the entity-level tax paid reduces the federal taxable income distributed by the entity and Iowa taxable income, the amount of the credit is reduced by multiplying the credit by a percentage equal to 100% minus the top individual tax rate in the year of election. For example, the partner or shareholder would receive a credit of 91.47% for an election applicable to 2022 (100% - 8.53%) or 94% (100% - 6%) for 2023. This mechanism is designed to ensure the state revenue neutrality of the tax.
The election must be made each year, is irrevocable for that year and is binding on the taxpayer and all partners or shareholders of the taxpayer. Partnerships and S corporations do not have to file composite returns for the election years. Nonresident partners and shareholders are not required to file Iowa income tax returns so long as their Iowa-sourced income is entirely derived from the electing entity and the credit received is sufficient to cover the individual’s Iowa tax liability. The law also provides that the tax should be reduced by certain franchise tax credits under Iowa code section 422.11 and composite credits under code section 422.16B. Net operating losses cannot be used to offset the tax due. The new provisions allow for elections to be made in tiered PTE situations.
Entities electing in 2022 are not required to make estimated tax payments. The department is also authorized to waive withholding penalties and interest related to 2022 elections.
Takeaways
The election does not provide guidance on electing for the 2022 year. Taxpayers should anticipate departmental guidance within the next few months. This was at least the third attempt to pass an election in the state, with early contention focused on the refundability of the credit and whether to include the add-back provisions reducing the credit amount.
With the enactment of the election, Iowa becomes the 33rd state to adopt a pass-through entity tax workaround. Versions of a PTE election are also on the Hawaii and Montana governors’ desks for signature and effective in 2023. Other proposals are pending in Maine, Pennsylvania and Vermont, with the Maine and Vermont proposals passing one chamber in each of those states’ legislatures. Iowa is the fourth state this legislative season to adopt a workaround, with Indiana, Kentucky and West Virginia all adopting similar taxes, and all retroactively effective to 2022. For more information or background on PTE elections, please read our article, Pass-through entity elections are here to stay: What you need to know.
Finally, a number of proposals to extend the state and local tax deduction limitation have been discussed or proposed in Congress as anxiety grows over the scheduled sunset of the cap after 2025. Two proposals have discussed raising the limitation from $10,000, with one to $15,000 with inflation adjustments and another to $200,000. Another proposal eliminates the cap for incomes under $400,000; still, others have argued for the complete rollback of the cap before its sunset. No proposal has yet received broad bipartisan support and it remains unclear whether the deduction will be included in any potential tax bill this year.
Taxpayers with questions on Iowa’s new PTE election or with questions on PTE elections generally should consult with their state and local tax advisers.
