Could Your Organization Benefit by Electing Pass-Through Entity Taxation?

Connecticut was the first state to adopt the PTET regime to circumvent the SALT cap, even without the IRS’s blessing that the tax would be considered a valid above-the-line pass-through deduction. It became effective for tax years beginning on or after January 1, 2018. Unlike all states that followed, Connecticut’s PTET is mandatory. It is applicable to S corporations, partnerships, and limited liability companies (LLCs) that are treated as partnerships or S corporations for tax purposes.

A flat tax rate of 6.99% is imposed on a rather complex calculation of the pass-through’s taxable income. A PTE may annually elect to use the “standard base method” or the “alternative base method.”

• Standard — The entity’s taxable income is based on “Connecticut sourced income” as determined under the personal income tax rules, regardless of who owns the entity.
• Alternative — Taxable income not only includes Connecticut-sourced income but also “unsourced income” (i.e., income that is not taxed in another state), both of which are attributable to only individuals, trusts, and estates.

In addition, multiple related pass-through entities may file a combined return to determine the tax. This, and which method is selected, could result in drastically different taxes and results for the PTE and its owners. Running the numbers first with your tax advisor can help avoid unintended consequences.

Pass-through owners receive a credit against their tax liability (corporate business tax or personal income tax) equal to 87.5% of their share of the PTET paid by the entity. Previously, this percentage was 93.01%, which was the mathematical percentage needed to make, in theory, an individual owner “whole.” However, as a revenue-raising measure, the percentage was soon reduced to 87.5% for tax years beginning on or after January 1, 2019, requiring most owners to pay some amount of Connecticut tax.

The Massachusetts PTET applies to S corporations, partnerships, and LLCs treated as S corporations or partnerships for tax purposes and is an annual election made by the pass-through entity. The elective tax is effective for tax years beginning on or after January 1, 2021 and applies until the repeal of the federal state tax deduction limit or the deduction limit expires.

A flat tax rate of 5% is applied to “qualified income taxable in Massachusetts,” which is generally computed under Massachusetts’ personal income tax provisions. Although certain capital gains that are passed through to “qualified members” (i.e., individuals, trusts, or estates) may be subject to Massachusetts’ 12% tax rate, there is no provision to utilize the higher rate for purposes of determining the PTET. In addition, nonresident tax withholding may occur if an opt-form was not received.

The qualified member is allowed a refundable credit for the PTET paid by the entity equal to 90% of the member’s distributive share of the entity’s tax. As a result, due to the potential different tax rates applied with respect to certain capital gains and the reduced credit amount, a member may find that the credit pass-through entity does not entirely cover their Massachusetts personal taxes on the passed through income, potentially requiring estimated tax payments or tax due with the filing of their Massachusetts personal income tax return.

For taxable years beginning on or after January 1, 2020, pass-through entities may elect to pay the Pass-Through Business Alternative Income Tax (BAIT) on behalf of S corporations that have made the New Jersey S corporation election, partnerships, and LLCs treated as New Jersey S corporations or partnerships for tax purposes. The entity must have at least one member who is liable for tax on their share of the PTE’s income under the Gross Income Tax Act (e.g., an individual). The election is to be made on or before the original due date (without extensions) of the entity’s return. A group of commonly owned pass-through entities may file a consolidated BAIT return.

Graduated tax rates ranging from 5.675% (first $250,00 of taxable income) to 10.9% (taxable income over $5 million) are applied to the entity’s New Jersey-sourced income (i.e., taxable income apportioned to New Jersey). Although the New Jersey tax is paid on the entity’s New Jersey source income, the legislation currently does not change existing nonresident withholding requirements for those entities that elect to pay the BAIT. In addition, the tax must be calculated on every owner’s share of the distributive taxable income, including tax exempt owners (e.g., 501(c)(3) entities and exempt retirement plans). These entities may then separately claim a refund for their share of the amount of the tax that was paid by the PTE.

The owners receive a refundable credit equal to 100% of the owner’s pro rata share of the tax paid by the PTE.

The New York state PTET applies to S corporations (i.e., New York S corporations), partnerships, and LLCs treated as New York S corporations or partnerships for tax purposes and is an annual election made by the PTE. The tax is effective for tax years beginning on or after January 1, 2021. Generally, the election must be made by the elective tax year’s due date of the first estimated tax payment (March 15 for a calendar-year entity). However, for the 2021 tax year only, the election can be made up to October 15, 2021.

Graduated personal income tax rates ranging from 6.85% (taxable income less than $2 million) to 10.9% (taxable income over $25 million) are applied to the share of the PTE’s taxable income attributable to New York state “Article 22 owners” (such as individuals, estates, and trusts — i.e., not owners who are corporations and upper-tier partnerships). As such, the tax is applied to the taxable income that would be taxed under New York’s personal income tax rules.

Taxable income subject to taxation is computed differently for electing New York S corporations and partnerships.

• S corporation — The tax is imposed on the entity’s “New York source income,” utilizing New York’s apportionment rules, regardless of a shareholder’s residency.
• Partnership — Taxable income is determined based on the residency of the partner. If the partnership has partners that are New York residents, 100% of the entity’s taxable income attributable to the resident partners is included in the taxable base. If the partners have nonresident partners, only the “New York source income” attributable to nonresidents is included in the taxable base.

The Article 22 owner receives a refundable credit for their share of the tax paid by the entity to be utilized against their income tax. Irrespective that an Article 22 owner may be able to fully offset their New York state tax liability with the passed through credit, New York currently requires that the owner continue to pay estimated tax payments as though the credit did not exist. Also, the New York entity may have made withholding tax payments on behalf of its nonresident owners, if it did not receive an opt-out form from the owner.

New York City already has an “unincorporated business tax,” which is a 4% income tax imposed on entities that are not corporations. New York City does not recognize the federal or New York state S election and imposes its tax under New York City’s corporation tax regime.

The 5.99% tax is computed on the entity’s apportioned “net income,” which generally means the net ordinary income, net rental income, and other business income of the entity sourced to Rhode Island. If the pass-through entity elects to pay the entity tax, the entity is not required to withhold Rhode Island income tax on its nonresident owners.

The owners of the entity can claim a credit for their proportionate share of the tax paid by the entity.

On May 4, 2021, Georgia enacted legislation that allows PTEs to elect to be subject to tax for tax years beginning on or after January 1, 2022. PTEs such as S corporations, partnerships, and LLCs treated as S corporations or partnerships for federal and Georgia tax purposes may make this annual, irrevocable election on their timely filed return (including extensions). However, only PTEs (whether an S corporation or partnership) that are 100% directly owned by persons eligible to be S corporation shareholders (generally, individuals and certain trusts) are eligible to make the election.

The PTE is responsible for the tax due to Georgia. The tax rate is currently a flat 5.75% on the S corporation’s or partnership’s allocated and apportioned income to Georgia.

If the PTE makes the election, both resident and nonresident members will be allowed an exclusion of their distributive share of income from the PTE on which Georgia tax was actually paid from its respective income

subject to Georgia income tax. Georgia resident members get no credit for PTET base on income paid to other states, nor offsets to income on their Georgia income tax return.

On May 17, 2021, South Carolina enacted legislation that allows for PTEs to elect to be subject to tax for years beginning on or after January 1, 2021. PTEs such as S corporations, partnerships, and LLCs taxed as partnerships may make this annual election on a timely filed return (including extensions) if the character of their members is totally comprised of (1) an individual, (2) an estate, (3), a trust, and/or (4) any other entity other than those taxed as corporations.

The PTE is responsible for the tax due to South Carolina, but if the PTE does not pay, direct and indirect owners are liable on their proportionate share of the PTET. The tax rate is currently a flat 3% on the electing PTE’s active trade or business income apportioned to South Carolina and none can be treated as income from allocated personal services. If the PTE makes the election, the owners exclude their respective share of the PTE’s income on their South Carolina return.

On June 30, 2021, Arizona Governor Doug Ducey signed legislation House Bill 2838, which creates a workaround of the federal and state local tax deduction limitation. For years beginning after December 31, 2021, partnerships, S corporations or LLCs can elect to pay the tax at the entity level rather than pass it down to the partners. Partners and shareholders of entities making the election would then allow an Arizona income tax credit equal to their share of the entity-level tax credit. Owners can opt out of the election, which does not restrict others from participating. The election is optional and must be made on or before the due date, including extensions, of the PTE’s return.

If election is made, the entity-level tax is applied at the rate of 4.5% to the portion of the taxable income attributed to the resident owners and the portion of taxable income derived from Arizona sources attributed to nonresident owners. The election only applies to individuals, trusts, or estates. An electing entity must add back to Arizona gross income any amount deducted for federal purposes for the entity-level tax and substantially similar taxes paid. Estimated payments are required if taxable income exceeds $150,000 in the preceding year.

A credit may be claimed by the owners for their portion of the tax paid. If the allowable credit exceeds an owner’s tax liability, the owner may carry forward the excess for up to five years. The owners can claim a credit for taxes substantially similar to the PTET paid to other states. The credit cannot exceed the amount that would have been allowed if the taxpayer was taxed at the individual level and not at the entity level.

On July 16, 2021, California Governor Gavin Newsom signed Assembly Bill 150, allowing this workaround for S corporations and partnerships for tax years beginning on or after January 1, 2021. PTEs can elect to pay a 9.3% income tax if they do not have owners that are partnerships, are not part of a combined reporting group, and are not publicly traded. Owners of entities who pay personal income tax can claim a credit equal to the tax the entity pays, limited to the tentative minimum tax. The workaround will be in effect through tax years beginning before January 1, 2026 to match the timing of the federal deduction limit law.

The election is irrevocable and must be made annually on the original timely filed return in the form and manner as prescribed by the Franchise Tax Board (FTB). We are waiting on guidance from the FTB regarding how to make the election and whether “timely filed” includes extensions.

Each owner within an eligible PTE can consent to have their share of income subject to the PTET. If an owner does not consent, it does not preclude other owners from making the annual election to pay the tax. The tax withheld will be computed based on the electing owner’s distributive share of pass-through income for residents, and the electing owner’s distributive share of California source income for non-residents.

Governor Jared Polis signed HB 21-1327, enacting the election in Colorado for tax years beginning on or after January 1, 2022. The election is made annually by the entity and is binding on all members of the entity. Eligible entities include all PTEs and their members, excluding C corporation members who are unitary with the entity.

The tax rate on the electing entity is the individual Colorado rate of 4.55%. This rate is applied to the taxable income attributable to the resident owners and the portion of taxable income derived from Colorado sources attributable to nonresident owners. The tax must be paid in estimated payments throughout the year using the same timeline and rules as corporate taxpayers. Credits, net operating losses, and other tax attributes that normally would pass to the owners will remain with the entity and can be utilized by the entity or carried over on future entity returns.

Colorado, is one of the few states that allows the member to deduct, as a subtraction, the income passed through to them from the electing entity. The nature of this treatment means that any 199A deductions claimed on the federal return should be added to the Colorado income. Additionally, resident members of an electing entity are not allowed a credit for taxes paid to other states on income from the electing entity. Rather, this credit is taken on the entity return. Lastly, because of the deduction treatment, members who have ownership in multiple electing entities may find this method does not benefit the owner.

On July 19, 2021, Oregon enacted legislation that allows PTEs to elect to be subject to tax for tax years beginning on or after January 1, 2022 and before January 1, 2024. Members of PTEs, such as partnerships, S corporations, or LLCs electing to be treated as a partnership or S corporation may make an annual election to be subject to tax at the entity level. The members must be individuals subject to Oregon personal income tax or entities that are pass-through entities owned entirely by individuals subject to Oregon personal income tax. Consent is required from all members of the electing PTE or may be made by any officer, manager, or member of the electing PTE who is authorized under law or the entity’s organizational documents to make such an election. The annual election must be made on or before the due date, including extensions, of the PTE’s return

The tax rate is 9% of the first $250,000 of “distributive proceeds” and 9.9% of any amount of distributive proceeds in excess of $250,000. “Distributive proceeds” is defined as the net income, dividends, royalties, interest, rents, guaranteed payments, and gains of a PTE, derived from or connected with sources within Oregon.

An Oregon personal income taxpayer that is a member of an electing PTE is allowed a credit against Oregon personal income tax due for their share of tax paid by the pass-through entity. The legislation does not contain a provision related to credits for similar entity-level taxes paid to other states.

On June 28, 2021, Illinois Governor J.B. Pritzker approved Senate Bill 2531, which allows S corporations and most partnerships to elect to pay a 4.95% entity-level state tax on apportioned Illinois income. The election is available to PTEs whose year ends on or after December 31, 2021. A distinct election needs to be made for each taxable year and once the election is made, it is irrevocable for that year. The PTET election is distinct from the Illinois replacement tax and does not change the PTE’s requirement to pay the replacement tax.

Members of an electing PTE are allowed a credit against their Illinois income tax equal to 4.95% times the member’s distributive share of net income. The credit cannot exceed the member’s share of tax actually paid by the PTE. As discussed previously, the PTE credit can only be claimed against income tax, not the Illinois Replacement Tax.

Careful considerations of the effect of nonresident members should be reviewed before making the PTE election as income that would otherwise be allocable to a nonresidents state, will now be allocated to the electing PTE.

Minnesota also enacted a PTET election this summer, following the trend of states doing so in 2021. The election is available for tax years beginning on or after January 1, 2021. The election is made with the return on the due date or extended due date of the entity’s annual income tax return. PTEs owned by Minnesota residents and Minnesota nonresident individuals, estates, or trusts are eligible to have the tax paid at the entity level if the owners holding more than a 50% ownership make the election. For an entity that makes the election, there would be no nonresident withholding requirement. PTEs are not required to make estimated payments but are permitted to do so, which would relieve the individual owner’s obligation of making estimated payments.

The PTET is the sum of each owner’s tax liability, calculated by applying Minnesota’s highest individual income tax rate of 9.85%. Nonbusiness deductions, standard deductions, and personal exemptions are not allowed when calculating each owner’s tax liability. Credits and deductions are only allowed to the extent they are permitted at the individual owner level. Minnesota residents are still allowed a credit for tax paid on their pro-rata share of the income tax paid on their behalf by the entity, which is not limited by the applicable rate on the individual return. Refunds due on overpayments of the PTE tax are paid to the owners.

Wisconsin has one of the more longstanding PTET elections. PTEs, specifically S corporations as well as partnerships and LLCs, may elect to be subject to income tax at the entity level. Individual owners of electing PTEs would get a corresponding subtraction on their Wisconsin individual income tax returns for their K-1 distributive share of the PTE’s income. The effective date for S corporations is January 1, 2018, and January 1, 2019 for other PTEs.

The election is flexible in that it is made on an annual basis. PTEs may opt in or out of the entity-level tax regime without limitation or penalty. The election may be changed up to the extended due date of the return. More than 50% of the shareholders, partners, or members must approve the election. The Department of Revenue has not provided a form nor does it require the election to be filed. Documentation of the election must be maintained by the PTE.

Consider carefully when making this election, as the only credits allowed against the entity-level tax are taxes paid to other states. The Wisconsin manufacturing and agricultural credit and research and development credits are not available to offset the entity-level tax.