State Pass-through Entity Taxes Provide Benefit for Business Owners

BY ALEX MASCIANTONIO, CPA

BUSINESS OWNERS may be eligible for a relatively new tax benefit in many states known as pass-through entity taxes. This tax benefit is available to pass-through entities such as S corporations, partnerships, and LLCs taxed as S corporations or partnerships.

The Tax Cuts and Jobs Act of 2017 generally limits an individual taxpayer’s federal itemized deduction for state and local income taxes to $10,000. This provision caused angst among taxpayers in states which impose relatively high income taxes, such as New Jersey and New York. In response to the provision, many states enacted entity-level taxes on pass-through entities. The entity-level tax circumvents the $10,000 tax deduction limitation because the tax is considered imposed on the entity—not the individual owners. The IRS permitted the federal tax deduction for state pass-through entity taxes in IRS Notice 2020-75.

Many states allow the taxpayer to elect the entity-level tax treatment. In some states the entity-level tax treatment is mandatory. States who enacted pass-through entity taxes include Maryland, New Jersey, New York, California, Massachusetts, and Wisconsin, among others. Delaware, Ohio, and Pennsylvania are some states which have not yet enacted pass-through entity taxes.

An example is a Delaware S corporation that operates in multiple states including California and is owned completely by one person. Assume that California imposes $50,000 in income-based taxes on the shareholder or the entity if the pass-through entity tax is elected. Before enactment of the California entity-level tax, the California income-based taxes would be limited to a $10,000 federal tax deduction on the owner’s personal tax return. Electing the new California passthrough entity tax permits the S corporation to take a tax deduction for the entire $50,000, resulting in at least an additional $40,000 federal tax deduction for the owner.

An analysis can be performed to determine whether electing the state pass-through entity taxes is advantageous. The taxpayer’s exposure to state taxes relative to the $10,000 general limit should be evaluated. The entity level state tax rate should be compared to the relevant personal state tax rate. The complexity and cost of compliance with electing the entity-level taxes should also be analyzed.

Another factor to consider is potential future tax rule changes. The personal federal itemized deduction limit for state and local income taxes could be increased from the current $10,000 threshold. An increase to this limit could make pass-through entity state taxes no longer beneficial for taxpayers who fall under the new threshold. Potential future IRS and state rules in this relatively new area could also impact decision making.

Pass-through business owners should consider whether electing state entity-level tax treatment is advantageous. Eligible high-income taxpayers may obtain a significant tax benefit. This is an area with evolving rules and should be closely monitored by applicable taxpayers and tax professionals.

Alex Masciantonio, CPA is a tax partner with Gunnip & Company LLP in Wilmington, Delaware.