Pass-Through Entity Tax Considerations for Government Contractors

At a glance:

• The main takeaway: Provisions in the Tax Cuts and Jobs Act led to the creation of new pass-through entity tax election statutes in many states, some of which may have significant implications for you and your business.
• The impact on your business: Understanding how PTET election rules affect your business can help you mitigate or avoid the provisions in the Tax Cuts and Jobs Act, leading to a lower tax bill and fewer headaches.
• Next steps: Get a sense for the considerations and implications of the new PTET election statutes by reading this piece, then schedule a consultation with Aprio’s GovCon team to turn these insights into new and more advantageous tax strategies for you and your business.

Schedule a consultation with Aprio’s Government Contracting team today.

The full story:

The 2017 Tax Cuts and Jobs Act (TCJA) had many far-reaching effects on the U.S. Tax Code, including the annual $10,000 limitation imposed on deductibility of state income taxes paid by individual taxpayers. This was a pivotal change for pass-through entity owners, as the only option at the time was to pay the state income taxes on business income earned at the individual level and deduct those taxes paid on their individual federal income tax returns.

Needless to say, the limitation resulted in many owners of pass-through businesses such as S corporations and partnerships losing the benefit of thousands of dollars of tax deductions. In response, Maryland, Virginia and various other states have enacted workarounds to this law in the form of Pass-Through Entity Tax (PTET) elections and filing options.

What is a Pass-Through Entity Tax (PTET) Election and Filing?

PTET elections allow pass-through businesses to elect and pay state taxes at the entity level (vs. the individual level) which in turn enables the business to deduct the state taxes paid at the federal level. The end result is that reduced federal income  is passed through to the business owners, allowing them the full benefit of the state taxes paid without the need to report deductions subject to limitation on their individual returns.

What are the GAAP consequences of making a PTET election?

While PTET payments are always expensed for federal tax purposes, questions have arisen regarding how PTE taxes should be treated under US GAAP (Generally Accepted Accounting Principles). Based on the guidance of FASB ASC 740, PTET payments will either be accounted for as equity transactions if attributable to the owner(s), or as income tax expense if attributable to the entity. The applicable treatment is based on each state’s unique laws and regulations, and either treatment will have an impact on a company’s financial statements, specifically net income, and any debt covenants with lenders.

Factors to consider include whether the laws and regulations of a particular jurisdiction allow owners to file tax returns and claim a credit for taxes paid by the entity as well as if the laws indicate that payments are made on behalf of the owners. If the answers to these questions are yes, then the PTE tax payments would be considered attributable to the owners and should be recorded as a distribution and not as an expense. Examples of situations where income taxes are attributable to the entity or its owner(s) can be found in FASB ASC 740-10-55-226 through 740-10-55-228.

How does this Impact Government Contractors?

Many government contracting companies are structured as pass-through entities and often do business or have employees in various states which results in state income tax filing requirements and payment of tax. As mentioned above, by choosing a PTET election option, the owners of these companies can benefit from the reduced federal income resulting from the deduction of entity-level state taxes at the business level. GAAP treatment of these PTET payments, and the impact that treatment has on non-tax factors such as the company’s net income and debt covenants should also be considered.

For contractors operating in Maryland or Virginia, read on to learn more about state-specific PTET filing considerations.

Key Components of the Maryland & Virginia PTET Elections

State	PTET Election Due Date	PTET Tax Rate	Taxable Income Calculation for Residents vs. Nonresidents	PTET Removes Requirement for Nonresident Individual Filings in State?	U. S. GAAP Treatment of PTET Payments
Maryland	15th day of fourth month of following tax year (April 15th for calendar year filers)	8.0% for individual owners, and 8.25% for other entity owners	Calculated based on Maryland adjusted federal income post-apportionment for both residents and nonresidents.	No, a Maryland return is required for nonresidents to claim the MD PTE credit.	Considered attributable to the owners based on state laws and regulations and should be accounted for as distributions
Virginia	15th day of third month of following tax year (March 15th for calendar year filers)	5.75% for all owners	Calculated based on Virginia adjusted federal income post-apportionment for nonresidents, but pre-apportionment for residents. This fact can create disparities in the benefits received when both resident and nonresident owners exist and should be analyzed before making the election.	Yes, assuming nonresident owner has no other activity in the state.	Considered attributable to the owners based on state laws and regulations and should be accounted for as distributions

The bottom line

PTET elections create opportunities for pass-through entity owners to maximize the benefit from state income tax deductions for state taxes paid at the business level and should be considered in any state where the option is available. That said, Maryland and Virginia both offer PTET elections and filing options which could result in substantial benefits to qualifying taxpayers. The specific rules and requirements for each state are unique and should be considered before making the election so be sure to consult with your tax and financial statement advisors to determine if a PTET election is right for your business.

Schedule a consultation with Aprio’s Government Contracting team today to learn how to use these changes to PTET to your advantage.

Related Resources:

https://www.aprio.com/maryland-pass-through-entities-making-entity-level-election/

https://www.aprio.com/virginia-legislation-expands-eligibility-for-pass-through-entity-tax-election/

https://www.aprio.com/critical-decision-state-pass-through-entity-tax-elections/