Introduction Recently, there has been a significant uptick in the number of questions surrounding the tax considerations of deducting state pass-through entity (PTE) taxes for the 2021 tax year. As background, PTEs are not generally subject to income tax. A PTE’s income and losses are passed through to the PTE’s owners and reported on the[...]
Introduction
Recently, there has been a significant uptick in the number of questions surrounding the tax considerations of deducting state pass-through entity (PTE) taxes for the 2021 tax year. As background, PTEs are not generally subject to income tax. A PTE’s income and losses are passed through to the PTE’s owners and reported on the owners’ federal income tax returns. The Tax Cuts and Jobs Act (TCJA) limits an individual’s federal deduction for state and local taxes for tax years beginning in 2018 through 2025. State and local taxes imposed at the PTE level on an individual owner’s distributable share of PTE income, however, are not subject to the limitation. To date, 22 states have recently enacted elective PTE tax regimes, while five others and the District of Columbia have historically imposed mandatory PTE tax regimes. The elective PTE tax regimes are intended to reduce the federal pass-through income of owners by the amount of the PTE tax, effectively bypassing the state and local tax deduction limitation imposed by the TCJA. The PTE tax is included as a deduction on the PTE’s federal tax return, reducing the federal income distributed to the owners and, therefore, minimizing the federal tax burden that the TCJA’s limitation on state and local taxes has on the individual owners.
Frequently Asked Questions and Answers
The following frequently asked questions (FAQs) and answers provide guidelines for addressing many of the questions that have been arising particularly as it relates to accruing the PTE tax. As the PTE tax election parameters are different in each state, no conclusions can be drawn for all PTE tax elections; each state’s election procedures must be analyzed separately. As an example, some states require a PTE to make the PTE tax election by filing the state income tax return, whereas other states allow a PTE to make the election by making a payment at any time before the due date. All PTEs mentioned in the following FAQs are calendar year taxpayers and generally are accrual basis taxpayers unless otherwise specified. Furthermore, the FAQs generally involve the timing of a PTE’s deduction of the PTE tax liability for income earned in the 2021 tax year and in a state where the PTE election is voluntary.
FAQ #1 – A PTE that reports taxable income on the overall cash method of accounting pays the 2021 PTE tax during the tax year ended 12/31/2021 and makes the 2021 PTE tax election in the tax year ended 12/31/2022. When does the PTE deduct the PTE tax payment for federal income tax purposes?
FAQ #1 Answer – The cash basis PTE deducts the PTE tax payment in the tax year in which the amount is paid, irrespective of when the election is made by the PTE. In contrast, a cash basis PTE that pays the 2021 PTE tax during 2022 is entitled to deduct that payment in the 2022 tax year.
FAQ #2 – The PTE properly makes a state’s 2021 PTE election by 12/31/2021 and pays the associated PTE tax liability by 12/31/2021. When does the PTE deduct the PTE tax payment for federal income tax purposes?
FAQ #2 Answer – The PTE deducts the 2021 PTE tax liability in the 2021 tax year. Under an overall accrual method of accounting, the taxpayer takes into account the liability in the taxable year in which all the events have occurred that establish the fact of the liability (here, the making of the PTE election), the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. In the case of a taxpayer’s liability to pay a tax, economic performance occurs as the tax is paid to the governmental authority that imposed the tax.
FAQ #3 – The PTE properly makes a state’s 2021 PTE election by 12/31/2021 and pays the associated PTE tax liability by March 15, 2022. When does the PTE deduct the PTE tax payment for federal income tax purposes?
FAQ #3 Answer – Generally, the PTE claims the deduction in the tax year in which the tax is paid to the governmental authority that imposed the tax. However, because the election was made in 2021 and payment of the tax is made at the earlier of 8-½ months after year end or the date the taxpayer timely files (including extensions) the 2021 federal income tax return, the PTE may use the recurring item exception to claim the deduction in the 2021 tax year as long as all the requirements are met. Under the recurring item exception as prescribed in section 461(h)(3), an item shall be treated as incurred during any taxable year if (i) all the events have occurred that establish the fact of the liability (here, the making of the PTE election), (ii) the amount of the liability can be determined with reasonable accuracy, (iii) economic performance (here, payment of the tax) with respect to such item occurs on or before the earlier of the date the taxpayer files a timely, including extensions, return for that taxable year, or 8 ½ months after the close of that taxable year, (iv) such item is recurring in nature, and (v) either such item is immaterial or the accrual of the item for that taxable year results in a better matching of the liability with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs. See FAQ #6 for accounting method change implications to the recurring item exception.
FAQ #4 – The PTE does not make a state’s 2021 PTE election by 12/31/2021 and takes no action to demonstrate an intent to make the PTE election by year end. The PTE makes the 2021 PTE tax election and pays the 2021 PTE tax liability by March 15, 2022. When does the PTE deduct the PTE tax payment for federal income tax purposes?
FAQ #4 Answer – The PTE deducts the 2021 PTE tax liability payment in the 2022 tax year, the year in which the tax is paid to the governmental authority, because the liability for the PTE to pay the tax is not fixed by the end of the 2021 tax year. Under an overall accrual method of accounting, the taxpayer takes into account the liability in the taxable year in which all the events have occurred that establish the fact of the liability (here, the making of the PTE election does not occur in 2021), the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. In the case of a taxpayer’s liability to pay a tax, economic performance occurs as the tax is paid to the governmental authority that imposed the tax.
FAQ #5 – Same facts as FAQ #4 except the PTE has taken some overt action to demonstrate an intent to make the PTE election by 12/31/2021, although it has not formally elected (e.g., through filing a return) to do so by year end. What are some indications of compelling facts that can be considered in determining whether the liability is fixed under the all events test by year end?
FAQ #5 Answer – In determining whether the liability is fixed under the all events test by year end, a combination of the following compelling facts may be considered. The list below is not intended to be exclusive, and the factors are not in any order of importance. No single factor is determinative in and of itself as this analysis is based on the totality of the facts and circumstances. (Note: Because the law is currently uncertain, discussion is recommended and the analysis would entail several hours to discern the facts, apply the facts to the law.)
• For states where the PTE can bind the entity without the owners’ consent or approval, did the PTE’s Board of Directors make or adopt a binding legal resolution by 12/31/2021 to make the PTE election for the 2021 tax year?
• Did the PTE undertake any modeling exercises by 12/31/2021 to determine whether to make the PTE election for the 2021 tax year?
• Does the PTE have an internal memorandum prepared as of 12/31/2021 concluding that it is favorable for the PTE to make the PTE election for the 2021 tax year?
• Did the PTE make any payment of the 2021 tax liability to the governmental authority by 12/31/2021?
• For states where the PTE cannot bind the entity without the owners’ consent or approval (e.g., the PTE’s owners must make the election, not the PTE itself), is there documentation of the owners’ intent received by 12/31/2021 to make the election for the 2021 tax year?
FAQ #6 – Assuming the PTE can meet the all events test by the end of 2021, can the recurring item exception be adopted for the PTE tax liability or does the PTE need to file an accounting method change?
FAQ #6 Answer – The PTE tax liability is considered a state income tax. If the PTE has not incurred any other state income taxes, it may adopt the recurring item exception by using it for the first year the PTE is subject to a mandatory tax or voluntarily elects to pay the tax. If the PTE has incurred state income taxes in prior years and has used the recurring item exception, then the PTE has established the recurring item exception as its method and should continue to use the recurring item exception for the PTE election tax. If the PTE has not used the recurring item exception for other state taxes it has incurred, and wishes to use it now, the PTE should evaluate whether it qualifies to make an automatic accounting method change to the use the recurring item exception for all of its state taxes under section 20.02 of Rev. Proc. 2022-14. The due date for filing an automatic accounting method change is the timely filing of the federal income tax return, including extensions, for the year of change.
FAQ #7 – Doesn’t the IRS in Notice 2020-75 require accrual basis PTEs to deduct the PTE election tax only in the year paid?
FAQ #7 Answer – We are aware that it is unclear whether Notice 2020-75 intends to prohibit the use of general accrual principles and the recurring item exception. Notice 2020-75 states that the IRS intends to issue proposed regulations to provide certainty to individual owners of partnerships and S corporations in calculating their state and local tax deduction limitations. The Notice makes repeated references to a deduction for the tax for the year the payment is made. We believe that an IRS notice is not sufficient authority to overrule the general accrual accounting method principles including the recurring item exception under section 461. Therefore, if a PTE qualifies to use the recurring item exception, we believe that it may apply it to accelerate the deduction to the year the liability is fixed and determinable.
FAQ #8 – Assuming an entity is otherwise eligible for making the state PTE tax election (and no other state and local tax issues), can you describe the types of partnerships that should consider making a PTE election? In particular, what are the implications in the following situations: (1) the partnership generates both line 1 non-separately stated income and separately stated income such as capital gains, and (2) the partnership provides services to another entity and receives both management fees and carried interest allocations?
FAQ #8 Answer – Notice 2020-75 states that the Treasury Department and the IRS intend to issue proposed regulations clarifying that “Specified Income Tax Payments” are deductible by partnerships and S corporations in computing their non-separately stated income or loss. Further, Notice 2020-75 states that the forthcoming proposed regulations will provide that Specified Income Tax Payments will be reflected in a partner’s or S corporation shareholder’s distributive or pro-rata share of non-separately stated income or loss reported on a Schedule K-1 (or similar form). Based on guidance contained within Notice 2020-75 as well as relevant legislative history, partnerships that incur a PTE tax expense associated with Line 1 non-separately stated income should be eligible to claim a deduction for their PTE tax expense against this income. Additionally, PTE tax expense incurred with respect to separately stated items generated from investment activity should not be reflected as a Line 1 non-separately stated expense. However, it may be possible for a partnership that recognizes separately stated income, e.g., capital gain, associated with a trade or business to benefit from a PTE tax deduction. This result is most likely to be seen in the context of management companies providing services to investment funds in exchange for a portion of gain recognized on dispositions of investment activities.
FAQ #9 – How is the PTE tax expense reported on Form 1065, Schedule K-1 when the expense relates to separately stated and non-separately stated items?
FAQ #9 Answer – A PTE tax expense generated in connection with a trade or business should be treated as an expense associated with such activity. Consequently, a PTE tax expense incurred in connection with non-separately stated income should be netted against these items of income and reported as a Schedule K-1, Line 1 amount. Where a determination has been made that separately stated items of income, e.g., capital gain allocated as part of a carried interest, are associated with a trade or business, the associated PTE tax expense should be reported on Schedule K-1, Line 13W. Note that most investment funds do not conduct an active trade or business pursuant to section 162. Therefore, any PTE tax expense incurred at the investment fund level is likely to be treated as a section 212 investment expense. When a separately stated item of income is recognized at the management company level, care needs to be taken in evaluating the extent to which such income is attributable to a trade or business vs. investment activities.
FAQ #10 – For PTE taxes reported on Form 1065 Schedule K-1, Line 1 or Line 13W, or on Form 1120- S Schedule K-1, Line 1 or Line 12S (separately stated PTE taxes), how do these items flow to Form 1040 Schedule A? For example, should the expense flow to Schedule A, Line 6 as “other taxes” which is not subject to the $10,000 limit? If so, would this still be an AMT preference item?
FAQ #10 Answer – PTE taxes reported on Line 1 of Schedule K-1 are not separately reported on Form 1040. Instead, they offset ordinary business income reported by the PTE and are included in the ordinary business income (loss) reported on Form 1040 Schedule E. Separately stated PTE taxes may be a “Specified Income Tax Payment” as that term is defined in Notice 2020-75. The Notice broadly defines Specified Income Tax Payment as: “…any amount paid by a partnership or an S corporation to a State, a political subdivision of a State, or the District of Columbia (Domestic Jurisdiction) to satisfy its liability for income taxes imposed by the Domestic Jurisdiction on the partnership or the S corporation. This definition does not include income taxes imposed by U.S. territories or their political subdivisions. Thus, this definition solely includes income taxes described in section 164(b)(2) for which a deduction by a partnership is not disallowed under section 703(a)(2)(B), and such income taxes for which a deduction by an S corporation is not disallowed under section 1363(b)(2).” The Notice further provides that any Specified Income Tax Payment is not taken into account in applying the state and local tax deduction limitation to an individual.
The legislative history of the TCJA bolsters the Notice’s broad definition. When discussing the then-proposed $10,000 limit on an individual’s itemized deduction for state and local income taxes, footnote 170 of H.R. Rep. 115-466 noted: “The proposal does not modify the deductibility of GST tax imposed on certain income distributions. Additionally, taxes imposed at the entity level, such as a business tax imposed on pass-through entities, that are reflected in a partner’s or S corporation shareholder’s distributive or pro-rata share of income or loss on a Schedule K–1 (or similar form), will continue to reduce such partner’s or shareholder’s distributive or pro-rata share of income as under present law.”
Present law prior to the TCJA did not have any limitation on the deduction of a partner’s or S corporation shareholder’s distributive or pro-rata share of income taxes on separately stated PTE taxes. Despite neither the Notice nor the TCJA legislative history directly addressing separately stated PTE taxes, there likely is reasonable basis for reporting separately stated PTE taxes attributable to trade or business income (such as income from a carried interest awarded for services) as “other taxes” on Form 1040, Schedule A, Line 6.
Taxes reported on Form 1040, Schedule A, Line 6 are not subject to the $10,000 limitation on the deduction for state and local income taxes. They are, however, an AMT add back item. To avoid accuracy-related penalties, Rev. Proc. 2021-52 requires that any taxes reported on Line 6 be adequately disclosed by listing the type(s) of tax and the amount(s) paid.
PTE taxes imposed on investment income, including from a carried interest not awarded for services, would still be considered a section 212 expense and subject to the $10,000 limitation on deductible state and local income taxes, which are reported on Form 1040, Schedule A, Line
FAQ #11 – Is the PTE tax expense a deduction for the NIIT under section 1411? And if so, would it be only for the separately stated PTE tax expense or also for the non-separately stated PTE tax expense?
FAQ #11 Answer – Section 1411 imposes a net investment income tax (NIIT) on net investment income (NII). Certain expenses allocable to investment income, including state, local and foreign income taxes attributable to investment income, are deductible in computing NII provided they are deductible for regular income tax purposes. Deductible state, local and foreign income taxes allocable to NII are deducted on line 9b of Form 8960. Trade or business income, such as income from a carried interest awarded for services, is included in NII only if the taxpayer is passive as to that activity or engaged in the trade or business of trading in financial instruments or commodities.
State and local income taxes allocable to investment income and deductible on Form 1040, Schedule A, Line 5a (subject to the $10,000 state and local tax limitation) will be deductible for NIIT purposes up to the $10,000 limitation. Where separately stated PTE taxes are attributable to NII and deductible for federal income tax purposes on Form 1040, Schedule A, Line 6, such taxes also are deductible for NIIT purposes without limitation.
If, however, the separately stated PTE taxes are attributable to trade or business income not included in NII, such as income from an activity in which the taxpayer materially participates, the separately stated PTE tax imposed on such income would not be deductible against NII.
Notwithstanding the forgoing, capital gains reported on Schedule K-1 are not always identified as related to a carried interest earned in connection with services provided. In that case, where capital gain income related to a carried interest earned in connection with services provided is included in NII on Form 8960, any separately stated PTE tax allocable to such capital gain income should be deductible against NII. Non-separately stated PTE taxes are netted against ordinary business income reported on Schedule K-1, Line 1. Ordinary business income is not NII and, therefore, the non-separately stated PTE taxes embedded therein are not deductible against NII on Form 8960.
FAQ #12 – Would family partnerships that have only investment income from brokerage or underlying K-1s be eligible for a PTE tax benefit or would the PTE tax expense result in a section
212 deduction?
FAQ #12 Answer – The discussion in Notice 2020-75 focuses on non-separately stated items of income reported on Schedule K-1, Line 1 with an apparent objective of allowing a deduction associated with trade or business income generated by a partnership. In a situation where the partnership conducts an investment activity and is generating investment income, it is anticipated that any PTE tax expense would be treated as a section 212 investment expense subject to applicable limitations on deductibility.
FAQ #13 – Assume an upper-tier partnership holds investments in flow-through entities where the lower-tier entities operate a trade or business. Is there benefit for the upper-tier partnership to make the PTE election?
FAQ #13 Answer – The lower-tier partnership will likely report its trade or business income on Schedule K-1, Line 1, and the flow-through income will be similarly reported by the upper-tier partnership. If the upper-tier partnership makes a PTE election, it will incur a PTE tax expense associated with the Line 1 trade or business income. Consistent with guidance provided in Notice
2020-75, the PTE tax expense would then be reported as a non-separately stated item included on Schedule K-1, Line 1 as reported to the upper-tier partnership’s partners.
FAQ #14 – Assume an SMLLC is formed and generates taxable income from a section 162 trade or business that is reported on Schedule C. Would the taxpayer benefit from a PTE tax deduction by making an S election or setting up a new entity?
FAQ #14 Answer – Due to the extensive state and local tax as well as federal tax considerations, it is not possible to provide a one-size-fits-all answer. However, in the general situation of a taxpayer generating trade or business income, a PTE tax expense may result in an overall tax benefit to an individual owner. A more comprehensive review of the potential benefits to be derived from the PTE tax deduction is likely warranted. Care needs to be exercised before making any choice of entity decisions that could have long-term implications beyond the incremental benefits that may be viable via a PTE election.
FAQ #15 – Should partnerships consider amending their operating agreements to ensure proper allocation of the PTE tax expense? Related to this question, can partnerships specially allocate PTE tax expenses to those partners who can derive the most benefit from the deduction?
FAQ #15 Answer – A review of existing operating agreements should be part of the overall analysis regarding potential PTE elections. While not all operating agreements will need to be amended, situations may arise where clarification of certain allocation provisions may be warranted. Any special allocations of PTE taxes will need to be analyzed under the substantial economic effect rules under section 704. This analysis is necessary regardless of the nature of the underlying allocation methodology, e.g., targeted vs. safe-harbor allocations. Note that under the general rules of substantiality, it is typically not possible to specially allocate deductions among partners that have no economic impact but result in an overall decrease in the partner’s collective tax liabilities. Consider the following illustration of a special allocation that is unlikely to be sustainable:
OpCo, LLC generates $1 million of taxable income from a trade or business and makes a PTE election resulting in a PTE tax expense of $50,000. OpCo, LLC reports net taxable income of $950,000. Under the terms of the operating agreement, each of the four partners of OpCo, LLC is entitled to 25% of net income. Therefore, each partner is allocated net income of $237,500. However, assume OpCo, LLC amends its operating agreement to provide that the entire $50,000 PTE tax expense is to be allocated to Partner 1. The amendment also provides that other fully deductible expenses will be reallocated among the partners to ensure each partner continues to be allocated 25% of overall net income. Assuming the special allocation results in an overall reduction in the partner’s cumulative tax liability, e.g., because Partner 1 is able to fully benefit from the $50,000 PTE tax expense whereas other partners would have been limited, this allocation provision is likely to be disallowed under the substantiality rules.