Better Late than Never: Iowa, Kentucky and West Virginia Enact Elective Pass-Through Entity Taxes

By: Michael Colavito, SALT Director

At a glance

• The main takeaway: Iowa, Kentucky and West Virginia join the long list of states enacting elective pass-through entity taxes (PTET).
• Assess the impact: While every state PTET shares the same goal, taxpayers and practitioners need to be aware of the differences in how each state’s PTET operates, its eligibility criteria and its impacts on PTE owners.  
• Take the next step: Aprio’s State and Local Tax (SALT) team can assist PTEs and their owners with understanding their eligibility and the tax implications of state PTET elections to maximize benefits from these new systems. 

Schedule a free consultation today to learn more!

The full story:

It’s easy to lose count of the number of states that have enacted an elective PTET. In the last three months, six more states have implemented their own version of a PTET, which follows the 30 states (and NYC) that have already enacted similar regimes. This article will discuss the recent PTETs implemented in Iowa, Kentucky and West Virginia, and we will publish a separate article next month outlining the recently enacted PTETs in Montana, Nebraska and Hawaii.  

As a reminder, state PTETs are intended to provide a workaround to the $10,000 limit on the federal deduction for state and local taxes as enacted by the Tax Cuts and Jobs Act (TCJA) of 2017. This is accomplished by allowing a pass-through entity (PTE), which typically includes entities treated as a partnership or S corporation for federal income tax purposes, to elect to pay income tax at the entity level. As permitted in IRS Notice 2020-75, the PTE is entitled to deduct the PTET paid on its federal return, which lowers the net income of the PTE that flows-through to owners of the PTE. Generally, the owners of the PTE are then afforded a tax credit or income exclusion to account for the PTET paid at the entity level.

Highlights of the new PTET regimes in Iowa, Kentucky and West Virginia 

The newly-implemented PTETs in Iowa, Kentucky and West Virginia act as excellent reminders that although state PTETs all share the same goal, there are many differences in how state PTETs operate with respect to the PTE and its owners.  

Iowa

Governor Kim Reynolds approved Iowa’s PTET legislation (HF 352) on May 11, 2023. Outlined below are important features of Iowa’s PTET: 

• The PTET is effective for taxable years beginning on or after January 1, 2022.
• Iowa’s PTET election is an annual election, is irrevocable once made for the applicable tax year and is binding on all partners and shareholders of the PTE. The timing and manner of the PTET election will be prescribed by the department (presumably in future guidance).  
• The PTET in Iowa is imposed using the highest graduated individual income tax rate for the applicable tax year, which is 8.53% for 2022 and 6.0% for 2023.
• Unlike some states that have opted to impose their PTET on the non-apportioned net income base for the portion the distributive share of a PTE income attributable to resident partner/shareholders, the tax base for the Iowa’s PTET is fully apportioned regardless of the owners’ residency.
• A partner or shareholder of an electing PTE is permitted to claim a refundable credit for their share of the PTET paid by the electing PTE. However, the amount of the credit has been limited to ensure that the implementation of the PTET is revenue neutral. Due to the PTE’s net income being reduced by the income tax deduction created by the PTET, the amount of the refundable credit is reduced by multiplying the credit by a percentage equal to 100% less the applicable PTET tax rate. For example, for taxable year 2022, the credit will be equal to 91.47% (i.e., 100% minus 8.53%) of an owner’s portion of the PTET tax paid by the electing PTE. 

Kentucky

Kentucky’s governor signed House Bill 5 into law on March 31, 2023. House Bill 5 is the second version of Kentucky’s PTET. The legislation repealed the initial version, which was enacted as part of House Bill 360. Although regulations will likely be issued to clarify certain aspects of Kentucky’s PTET, House Bill 5 reflects the following general aspects of the tax:

• The PTET applies to taxable years beginning on or after January 1, 2022. 
• For the 2022 tax year, a PTE has until August 30, 2024 to make the PTET election. 
• For tax years beginning on or after January 1, 2023, the election can be made any time during the taxable year, or by the 15^th day of the fourth month after the close of the tax year, or the 15^th day of the 10^th month after the close of the taxable year for returns that have been extended. 
• Kentucky’s PTET election is made annually and is irrevocable.
• The tax base calculation of Kentucky’s PTET is based on the existing provisions addressing a non-electing PTE’s requirements of making withholding tax payments on behalf of nonresident owners. As such, it is unclear whether the tax base for the PTET will be fully apportioned or whether only the portion of the PTE’s net income attributable to nonresident owners must be apportioned.  
• Kentucky’s PTET legislation does not directly indicate the applicable tax rate. However, the legislation indicates that “all calculations for the return” shall be made using the rules applicable to the PTE nonresident withholding. Those rules require the nonresident withholding to be calculated using the highest individual income tax rate, which for 2022, 2023 and 2024 is 5.0%, 4.5% and 4.0%, respectively.
• PTE owners are eligible to receive a refundable tax credit for their proportional share of the PTET paid.

West Virginia

West Virginia’s PTET legislation (Senate Bill 151) was approved by Governor Jim Justice on March 28, 2023. Key characteristics of West Virginia’s PTET are as follows:

• The PTET is effective for taxable years beginning on and after January 1, 2022.
• The election must be made on an annual basis and is irrevocable for the respective taxable year.
• Although the PTET election is generally due on or before the deadline to file the return (i.e., March 15 for calendar year filers), the West Virginia Tax Division (Division) has issued guidance (Admin. Notice 2023-01) indicating that PTEs will be granted an automatic extension until September 15, 2023 to make the PTET election and file the applicable return for the 2022 taxable year. The 2022 election can be made even if a PTE has already filed a 2022 non-electing PTE return. The Division plans on providing additional guidance addressing the manner in which the election should be made and the procedure for filing amended returns. 
• The PTET base is West Virginia taxable income (i.e., income apportioned to West Virginia).  Although a bit unclear, the legislation does include language to suggest that the PTET base for resident owners may also include income from sources outside of West Virginia.  
• The tax rate for West Virginia’s PTET is the highest marginal individual income tax rate, which is 6.5% for 2022 and 5.12% for 2023. 
• PTE owners are eligible to receive a non-refundable tax credit for their proportional share of the PTET paid. Unused credits may be carried forward for up to five years.

The bottom line

As we near the point at which every state (i.e., those states that impose an income tax) has their own PTET, both taxpayers and practitioners need to be aware of the differences between each regime, the varying eligibility criteria and whether a particular state’s PTE election will have a different impact on owners with a different tax profile (e.g., resident v. nonresident, individual owners v. owners that are PTEs or corporations).  

Aprio’s SALT team can assist PTEs and their owners with understanding the tax implications of state PTET elections in order to maximize the benefits from these new tax systems. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

This article was featured in the June 2023 SALT newsletter.

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