Making a Pass-Through Entity Tax Election? Beware: Some Owners May Pay More Tax

By: Jeff Glickman, SALT Partner

At a glance

• The main takeaway: Pass-through entities should use caution if considering a pass-through entity tax election as some owners may end up paying more tax.
• Why it matters: There are variations among the states – both with and without pass-through entity taxes – that may impact how much a partner benefits from the election.
• Next steps: Aprio’s State and Local Tax (SALT) team can assist pass-through entities to make informed decisions to avoid potential negative tax consequences.

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The full story:

We have written several articles about these new state pass-through entity taxes (PTE Tax) that have been enacted in about 20 states (to date) as a workaround to the federal $10,000 limit on itemized deductions for state and local taxes paid.[1] Essentially, the PTE Tax imposes income tax directly on the PTE (it’s not a composite or withholding tax on behalf of individual owners), and the PTE owners receive a personal income tax credit for their share of the PTE Tax liability. As acknowledged in the IRS Notice 2020-75, the PTE is entitled to deduct the PTE Tax paid in full on its federal partnership return, which lowers the federal taxable income reported by and the federal income tax liability paid by each of the owners.

However, as is often the case with state taxes, there are variations among the states that have enacted PTE Taxes that may impact how much a particular partner benefits from the election after taking into account the state tax impact. One issue that needs to be examined closely is the applicability of a tax credit for resident taxpayers for PTE Taxes paid by the PTE to other states.  Recently, the Maine Board of Tax Appeals (BTA) published a decision denying its resident taxpayer a credit for Connecticut PTE Tax paid by a PTE.[2]

The taxpayer was a member of a PTE that did business in Connecticut, and therefore, the PTE paid the Connecticut PTE Tax.[3] The taxpayer filed a Connecticut non-resident income tax return, and after applying the PTE Tax credit (and any other tax benefits), he did not have a Connecticut income tax liability. The taxpayer then claimed a credit for the Connecticut PTE Tax on his Maine resident income tax return, which was denied by the state.

Under Maine law, a resident individual is allowed a credit against income taxes “for the amount of income tax imposed on that individual for the taxable year by another state of the United States . . . with respect to income subject to tax (in Maine) that is derived from sources in that taxing jurisdiction.”[4]

The taxpayer made two arguments. First, he claimed that the statute applies to the Connecticut PTE Tax paid by the PTE, and second, he claimed that he is entitled to the credit based on the Connecticut income tax imposed on him as an individual. As to the first argument, the BTA looked at a prior case law which held that the credit is applicable only to taxes “imposed on that individual.” Since the Connecticut PTE Tax is imposed on the PTE and not the individual, the credit provision is inapplicable.

Regarding his second claim, the BTA explained that an income tax imposed on an individual by another state means any income tax after credits have been applied. Since the taxpayer did not owe any Connecticut taxes after credits, there is no credit against his Maine income tax liability.

In contrast to Maine, there are states that provide residents an income tax benefit for PTE Taxes. For example, Massachusetts issued Directive 19-1 in which the state concluded that Massachusetts residents are eligible for an income tax credit for the Connecticut PTE Tax provided that the individual adds back to Massachusetts income his or her share of the PTE Tax.[5] In Georgia, resident pass-through entity owners are allowed a subtraction adjustment to federal adjusted gross income for their share of income subject to income tax at the PTE level.[6]

The bottom line

Nonetheless, for states that will not allow a credit or other adjustments to resident PTE owners, an election by the PTE to pay PTE Tax in another state may very well cause that resident owner to pay more combined federal and state income taxes than he or she would have had the PTE Tax election not been made. PTEs need to be aware of these tax consequences to make an informed decision, and Aprio’s SALT team can assist PTEs with these issues. 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.

Contact Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the October 2021 SALT newsletter.

[1] See these articles from our SALT Newsletters: (1) May 2018 – New York and Connecticut Enact SALT Deduction Cap Workarounds Not Involving Charitable Contributions; (2) Sept 2019 – Massachusetts Will Allow Residents to Claim Tax Credit for the Connecticut Pass-Through Entity Tax (3) Nov/Dec 2020 – IRS Approves Deduction for Entity-Level Income Tax Payment Made by Pass-Through Entities (4) April 2021 – New York and Georgia Legislatures Enact Pass-Through Entity Taxes and (5) August 2021 – California Enacts a Pass-Through Entity Tax a SALT Cap Workaround.

[2] [Individual Taxpayer] v. Maine Revenue Services, Maine Board of Tax Appeals Docket No. BTA-2020-1 (March 1, 2021).

[3] Connecticut is the only state right now with a mandatory PTE Tax.

[4] 36 M.R.S. § 5217-A.

[5] See article #2 in Footnote 1 above.

[6] O.C.G.A. 48-7-27(d)(1).

Disclosure

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.