State Pass-Through Entity Taxes

What is it and who does it apply to?

It all stems back to 2017 under the Tax Cuts and Jobs Act, whereby the legislation passed a law that said that you could not deduct state taxes in excess of $10,000 if you itemize your deduction. Therefore, that severely limited people’s ability to itemize their deductions if they had a large amount of state taxes. It not only affected those on wages, but pass-through entity owners, who may pay taxes on that pass-through entity income to many different states.

In the past, when they received the income, they would pay tax to a particular state and deduct it as an itemized deduction. However, now with this cap, they’re severely limited.

Connecticut is the first state that even thought about the pass-through entity tax “workaround”, which essentially allows the pass-through entity to pay the tax and get the deduction and flow it through to the owners. Fast forward to the end of 2020, the IRS ruled favorably and sanctioned this, so-called, workaround. Since then, many states have jumped on board and have passed this legislation.

Who it applies to: Partnerships, Limited Liability companies, S-Corporations and all of their owners

Diving deeper into the “workaround”

From an owner’s standpoint, the way this affects you is the deduction you take as an itemized tax payer for state taxes is going to go down. The theory behind this, and the way that the intent of the wall is supposed to work, is that the liability that is owed at the state level, from pass-through entity income, is now a liability on the entity itself (the partnership or the s-corp). Therefore, it helps the owner in the regards that they aren’t taxed in multiple states.

How many states does this affect?

It affects over 20 states as of now. Since 2020, there’s been a wave of states adopting this “workaround”. It’s important to remember that the way the tax is calculated varies from state to state.

Cost / Benefit Analysis

The obvious benefit is the federal deduction that the entity gets to take, compared to the owner not getting to take that because they’re capped out, especially in high tax rate states or high income situations. Being able to shift the income tax liability in this deduction to the flow through entity, where they can take it as a normal business expense, is the whole driver behind this.

The cost is compliance; on the front end, before you even decide to make the election, it’s important to run calculations to make sure that it makes sense for your situation. The other compliance cost is composite returns versus making this election. In a lot of states that give you a credit on this, you can’t take the credit on the composite return, so you’re going to end up with every partner filing a state return in a state where the partnership is making the election.

Federal Legislative Components to Keep in Mind

Ever since the legislation went through in 2017, the Fed has been toying around with the idea and has made constant proposals to try and adjust the cap. With new states passing this, almost weekly now, we can expect rules to constantly change, so this is definitely something to be aware of.

Please consult your tax advisor or reach out to Tony Switajewski and Dustin Hubbard of CLA if you have any questions.

You can find additional resources on CLA’s website here: www.claconnect.com