a guide on state pass-through entity tax elections (PTET)

What is an elective pass-through entity tax (PTET), and how does it help in tax planning? Many states have enacted legislation allowing businesses to elect pass-through entity taxation to help save on taxes. Even so, the states need more adequate guidance on this subject. This article will highlight some of the critical considerations you need to keep in mind concerning PTET.

What Is Pass-Through Entity Tax?

In general, the pass-through entity tax is an optional tax that partnerships and S Corporations may annually elect, allowing income tax to be paid and expensed at the entity level. The benefit of the PTET election is that the individual owners of the pass-through entity obtain a deduction for the state taxes paid by the entity, thereby avoiding the $10,000 Federal 1040 Schedule A limit on state tax deductions, commonly known as the SALT cap.

The PTET elections allow states to impose income tax directly on the pass-through entity (PTE). In addition, PTE owners may be entitled to a personal income tax credit for their share of the PTE tax liability or an exclusion of income on their personal state return, depending on the state. As of this writing, twenty-nine states with a state income tax have enacted PTET elections. Still, PTET elections are not available in ten states subject to individual income tax, including Nebraska and Iowa (as of tax year 2022).

How Does PTET Work?

The implementation of the PTET elections varies from state to state. The general process involves the pass-through entity making the election. The entity pays tax on any state income on that state tax return. The state tax payment is then claimed as a deduction on the PTE’s federal tax return, reducing ordinary income reported on the owner’s K-1 and, thus, on the owner’s Federal income tax return. On the owner’s state return, most states require an add-back of the state taxes deducted from federal income.

Since tax was already paid at the entity level, the states generally allow the owner to claim a credit for their share of PTET paid by the entity or allow the owner to exclude the previously taxed income. It is worth noting that the PTET election’s main objective is to provide a federal benefit to individual owners. As such, the PTET election may increase or decrease the total amount of state taxes owners pay.

PTET Considerations

• Which states have PTE tax rules in place? Click here to identify whether your state has PTE tax rules.
• Partnerships and S corporations are the only entities permitted to make PTE tax elections. In addition, each state has its exceptions, and it would be prudent to enlist the help of a licensed accounting and consulting firm to understand your eligibility.
• To make an election, you must know the details of the pass-through entity and its owners.
• How is an election made, and when is it required?
• Some states require that elections be held annually, while others are perpetual revocations that must be revoked.
• Do the PTET calculations allow for all owner types? Do some owner types prevent the entity from making an election?  Are owners allowed to opt out of PTET?
• Does an owner have tax attributes that negate the benefits of PTET (i.e., loss carryovers, tax credits, etc.)?
• The rate imposed on individual owners may be less than the PTET tax rate.
• Some states calculate PTET differently for residents’ share of income vs. nonresidents’ share of income.  This can result in disproportionate tax payments on behalf of shareholders, which may be problematic.  At the same time, it can produce significant federal income tax savings.
• Some deductions and credits may not be allowed when computing PTET.
• How do owners account for PTET if they still need to file a return with the state?
• Are nonresident owners required to file if PTET was paid on their share of income?
• Are PTET estimated payments required? Are owner estimated payments required if PTET is elected?

Partner With a Reliable Consulting Firm You Can Trust

Lutz has extensive experience with PTET elections and can assist with identifying opportunities, eligibility, and implementation.  If you would like to learn more about PTET elections, schedule a consultation with our team by contacting us. The Lutz State and Local Tax (SALT) group will work closely with you to identify tax strategies to help your business save money whenever possible.