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The Pass-Through Entity Workaround to Beat the SALT Limitation

In the past year, several states have created a pass-through entity tax (PET) to circumvent the $10,000 cap for the state and local tax (SALT) deduction. Louisiana and New Jersey are the most recent states to adopt such a tax.

Effective December 2017, the Tax Cuts and Jobs Act (TCJA) brought sweeping reform to the Internal Revenue Code. With the TCJA’s passing, the SALT itemized deduction was limited to only $10,000. The initial response by several high-tax states, including New York, New Jersey, and Connecticut, was to create plans in which charitable giving to state-specified organizations would allow taxpayers a dollar-for-dollar credit against their state income tax liability. Ultimately, the IRS deemed this workaround not acceptable, so states looked to other ways to side-step the SALT limitation. The idea of the PET was born, with the intention of imposing an income tax at the entity level, instead of the standard flow-through treatment where individual owners pay tax on the income. A PET allows the business entity to claim the state tax deduction on a federal income tax return, which is not subject to the TCJA $10,000 limitation placed on individuals.

Connecticut was the first state to create such a tax. Effective January 1, 2018, partnerships and S corporations are subject to a 6.99% income tax. While Connecticut’s PET is mandatory, other states’ PET is optional and requires the partnership or S corporation to make an election to pay taxes at the business entity level. On January 13, 2020, New Jersey enacted the Pass-Through Business Alternative Income Tax Act (BAIT), creating a PET with graduated rates from 5.675% to 10.875%. The BAIT took effect on January 1, 2020. Pass-through entities that wish to pay the NJ BAIT must make an annual election where either each member of the PTE consents or an authorized member-manager makes the election on behalf of the entity.

Wisconsin also has embraced the idea of an elective PET; however, the state introduced the move in phases depending on the taxpayer’s entity type. S corporations were first able to make a PET election for tax years beginning on or after January 1, 2018. Partnerships are allowed to make the election for tax years beginning on or after January 1, 2019. In Wisconsin, if the PET election is made, the entity’s Wisconsin income will be taxed at a rate of 7.9%. Nonresident shareholders or members with no other sources of Wisconsin income will not be required to file a state tax return, and Wisconsin residents can exclude the pass-through entity income from their Wisconsin adjusted gross income.

Recently, Louisiana enacted legislation that would allow pass-through entities to elect to be taxed as a C corporation for state purposes, beginning with tax years starting on or after January 1, 2019. Similar to Wisconsin, the election must be approved by the entity’s majority-owning shareholders. Louisiana started accepting elections for the 2019 tax year on February 1, 2020. It’s important to note that this election is binding for all subsequent tax years and the pass-through entity required to file the Louisiana Form CIFT-620, Corporation Income Tax and Franchise Tax Return, going forward.

Other states have considered a PET as well, so the list of those implementing a SALT deduction limitation workaround could certainly grow. As a result, it’s possible the IRS may block this workaround too, possibly by deeming a PET to merely be a withholding tax in disguise. For now, pass-through entity owners with business activities in the states discussed above need to be aware of the mandated PET taxes, such as Connecticut’s, and consider whether making a PET election in the other states is advantageous.

Learn more about SALT limitations at the American Institute of Certified Tax Planners.

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