For tax years 2018 through 2025, the Tax Cuts and Jobs Act of 2017 (TCJA) limits individual itemized deductions for state and local sales, income, and property taxes (referred to as SALT) and SALT deductions in the case of trusts and estates. The limitation is $10,000. The law does not affect the above-the-line deduction for taxes incurred and paid in an active trade or business or an activity entered into for profit.
Since the TCJA passed, 21 states have enacted legislation to partially mitigate the limit on individual state tax deductions by allowing pass-through entities to have state income taxes directly imposed on the entities. Previous state attempts around the rules, such as tax credits for charitable donations, did not meet federal approval. The IRS released Notice 2020-75 in November 2020, announcing its intention to issue proposed regulations authorizing the entity-level tax as an acceptable workaround to the $10,000 cap under the TCJA.
Connecticut was the first state to enact an entity-level income tax for pass-through entities due to the SALT deduction limitation. The income tax is imposed on pass-through entity types for tax years beginning or after January 1, 2018. Wisconsin soon followed with an elective entity-level income tax regime.
As of November 30, 2021, the following states have implemented entity-level income taxes for pass-throughs:
In addition, Ohio, Michigan, and Pennsylvania have similar bills at various stages of implementation.
The general state framework looks something like this:
Make an annual election during the year of intended effect up to the due date for filing the original return, including extensions. Some states have a specific form for the election; some elections can be made by checking a box on a timely filed return. Connecticut currently is the only state where the entity-level tax for pass-throughs is mandatory. The election can’t be changed for several years in some cases.
For the most part, the election applies to S corporations and entities taxed as partnerships for federal income tax purposes. In a couple of cases, business or statutory trusts and sole proprietorships may elect the entity-level tax.
In general, the tax rate is the highest marginal income tax rate for individual or corporate taxpayers in the state. Many states have a flat tax rate; other states impose a graduated tax rate.
States may provide a deduction, exclusion, or credit to resident taxpayers based on the amounts taxed at the entity level to prevent double taxation. Some states limit the credit to roughly 90 percent. Some credits are nonrefundable and may carry forward. In general, each state provides a credit equal to the similar tax paid to other states. The rules for nonresident partners vary. Some states have restrictions if any members, partners, or shareholders are pass-throughs or corporations.
Most states allow net operating loss carryforwards (or carrybacks).
Despite the higher marginal state rates applied to pass-through entity income, electing the entity-level tax regime should decrease overall taxes paid by entity owners, but this is not always the case. At a minimum, making the election should ease tax compliance costs. A potential cost to pass-through owners may be the loss of the credit for taxes paid to other states on their resident state filing.
The election by a pass-through entity to be subject to state taxes on its income will generally be beneficial to the owners of the pass-through entity but not always. An analysis is required to make this decision. Be sure to contact me prior to making this decision.