State Pass-through Entity Tax Election – Should Your S Corporation Bank Make the Election?

This blog was authored by my colleague Chan-Yu Wang – Tax Director, Financial Institutions.

With Ohio being the latest state to pass legislation allowing a pass-through entity tax (PTET) election in June 2022, nearly 30 states now allow S corporations and partnerships (pass-through entity or PTE) to be assessed an elective entity-level tax. This workaround is in response to the Tax Cuts and Jobs Act (TCJA) limiting the state and local tax (SALT) deduction for individuals who itemize to $10,000 through tax year 2025. Is it beneficial for your S corporation bank to make the PTET election?

Overview

In November 2020, IRS Notice 2020-75 announced that proposed regulations would clarify that state and local income taxes imposed on and paid by a S corporation or partnership on its income would be allowable as a deduction by the PTE in computing its non-separately stated taxable income or loss for the taxable year of payment. Therefore, the S corporation or partnership would not be subject to the SALT deduction limitation for shareholders and partners who itemize deductions.

Beginning in 2018, states have reacted to the $10,000 SALT deduction limitation by passing legislation allowing pass-through entities to make a PTET election.  However, the myriad ways in which the states have designed their SALT limitation workaround requires S corporation banks to assess whether the election makes sense given their individual situation. Generally, states have implemented two different PTET election regimes.

• Group 1 – PTE shareholders subtract their distributive share of PTE income from their personal income tax base (e.g. Colorado, Oklahoma, Wisconsin)
• Group 2 – PTE members remain taxable on their distributive share of PTE income, but receive a pass-through tax credit for their share of the PTET paid by the entity (e.g. California, Illinois, Minnesota)

The states vary in terms of when and how the PTET election is made such as whether it is an annual election or binding for the length of time the law is in place and which shareholders can be included in the election. S corporation banks need to evaluate the rules and consequences for making the election.

Considerations for Making the Election

Prior to deciding whether to the making the PTET election, S corporation banks should consider the following factors, including, but not limited to the following:

• What is the composition of shareholders?  Are the majority of shareholders nonresidents? If yes, does the state in which the nonresident shareholder resides allow a credit for taxes paid to another state?
• Does the S corporation have an employee stock ownership plan (ESOP) as a significant shareholder? Some states tax all shareholders (including ESOPs) at the highest individual marginal tax rate.
• Does the S corporation bank operate in multiple states and apportion income outside of its home state? Some states require the taxable income base on which the PTE tax is computed to be apportioned at 100%.

Tax Accounting Treatment

If an S corporation bank decides to make the PTET election, the U.S. GAAP tax accounting treatment should be analyzed for the state(s) in which a PTET election is made.  There are two main ways in which income taxes for a PTE are accounted for under U.S. GAAP accounting.

• Income taxes attributable to the PTE – accounted for under Accounting Standards Codification (ASC) Topic 740
• Income taxes attributable to the owners of the PTE – accounted for as an equity transaction

Management will need to consider several factors to determine whether a particular PTET is attributable to the entity or the owner. Factors include, but are not limited to:

• Whether an owner is permitted to or required to file a tax return and claim payment of tax by the entity as payment against the owner’s income taxes
• Whether income of the entity for which tax was paid by entity is excluded from the owner’s tax return
• Whether the tax liability is joint and severally liable by the owners of the PTE
• Whether the state statutes and regulations indicate that the tax payment is made on behalf of the owners

The consideration of allfactors should be analyzed to determine whether a particular PTET is within the scope of ASC 740.

How Can We Help?

For S corporation banks considering whether the PTET election is right for you, a careful analysis should be undertaken to determine pros and cons of making the election. Contact us to learn how we can help you evaluate making the PTET election.