Pass-Through Entity (PTE) Tax May Save Some Small Business Owners Money

If you’re an owner, shareholder, or investor in a pass-through entity such as an S corporation, you may be eligible to claim additional credit on your state income tax returns with the Pass-through Entity Tax. However, there is some confusion about when the deduction can be taken.

Today’s post explains what the PTE tax is and what it means for you.

What is Pass-Through Entity (PTE) Tax?
A pass-through entity (PTE) is a legal business entity that passes income it makes straight to its owners, shareholders, or investors. It is those individuals who are taxed on the entity’s income, not the entity itself. Common PTEs include partnerships, S Corporations, and trusts (to the extent that their income is taxed to their beneficiaries).

Currently, the personal federal income tax deduction for state and local income taxes and property taxes (SALT) is capped at $10,000 per year. However, in 29 states, including Massachusetts, PTEs can elect to be taxed at the entity level.

This means that the business entity will pay the state income tax due on its business income that would otherwise be paid on owners’ personal tax returns. Instead, owners, shareholders, and investors may be able to claim a credit on their state individual income tax return for the amount of their share of PTE tax paid by the entity and avoid the $10,000 SALT deduction limit.

Notice 2020-75 from the IRS announced that the IRS, along with the Treasury Department, will issue regulations that will clarify whether partnerships and S corporations can deduct state and local income taxes in computing non-separately stated taxable income or loss for the taxable year of payment.

The Issue
While it is clear that the deduction is allowed, it is not clear if it must be taken the year that the tax is accrued or the year it is paid.

On October 4, 2022, the American Institute of CPAs (AICPA) submitted a letter to the IRS and the Treasury asking for clarification on the guidance it gave in Notice 2020-75, and noting, “There is confusion among practitioners about whether a taxpayer would have a liability for income taxes in the current taxable year for an elective PTE tax where the election is made after the end of the current taxable year.”

The letter recommends that the IRS allow taxpayers to determine the timing of the deduction for the Specified Income Tax Payment (SITP) in accordance with the entity’s method of accounting.

What This Means for You
In addition to the 29 states that currently have PTE tax in effect, Missouri will allow PTE tax beginning in 2023, and more states have legislation pending. This means that an increasing number of PTEs and individuals are likely to be affected in the future.

Tonneson + Co is keeping a close eye on this situation so that we can provide our clients with the best and most timely information and ensure that they are able to claim all the deductions and credits they are eligible for. Contact us today if you have questions about PTE tax and whether it applies to you.