You maybe know this. But under current federal tax law, your itemized deduction for state and local taxes gets limited. That limit? $10,000.
For example, say you own a home and pay $10,000 of property taxes. And then also say you earn income in a state that taxes income and pay $20,000 of state income taxes.
You don’t in this situation get to deduct $30,000 as your state and local tax itemized deduction. (That was the old tax law.) Rather you get to deduct only $10,000. That $10,000 cap represents the state-and-local-tax (aka the “SALT”) deduction limit.
Pass-through entities like S corporations and partnerships, however, can sometimes use a trick to sidestep this $10,000 limitation: A pass-through-entity tax (PTET) election. Accordingly, if you’re a small business owner, you want to learn how a PTET election works.
Pass-through-entity Tax Basics
Suppose again that you own a home and pay $10,000 of property taxes. And that you also pay $20,000 in state income taxes.
To keep the math easy, let’s say your business earns $200,000. Finally, suppose that the $200,000 of income comes from a pass-through-entity. Something like an S corporation. Or partnership.
In this case, many states allow you to have your business—the S corporation or partnership—pay the $20,000 in taxes via the pass-through-entity tax election.
This effectively puts a $20,000 deduction on your business tax return. That means on your individual federal tax return, you pay federal income taxes on the $180,000 you have left over.
By the way, on your state income tax return? You calculate your state income taxes in the usual way. Probably your state return will show you owe $20,000. But then you’ll be able to deduct from your tax return’s state tax liability whatever the S corporation or partnership paid for your pass-through-entity tax.
If the pass-through-entity tax equaled $20,000 and you owe $20,000 in state income taxes, you won’t owe any more.
In effect, then, you use the pass-through-entity tax to dodge the state and local tax deduction limitation. And usually that should save you federal income taxes.
Note: If your marginal federal tax rate equals 24 percent, a $20,000 pass-through-entity tax saves you in theory $4,800 in federal taxes.
Three Caveats
A handle of important notes. First, the pass-through-entity tax for some states (like California) works as a nonrefundable credit. That means if the pass-through-entity tax is too big? Bigger than you would have needed to pay the state taxes? You may lose out.
This can happen if the the tax rate used for the PTE tax differs from the actual state income tax rate you would pay on your pass-through-entity income. Say the pass-through-entity tax uses a ten percent tax rate. But then your actual effective state income tax rate equals nine percent.
Note: California does allow taxpayers to carryforward unused credits for five years. The carryforward then may allow taxpayers to recover unused credits.
A second thing to note. The attractiveness of the pass-through-entity tax gets murkier if you reside in a state with income taxes and you earn your money (at least some of it) from other states that also tax that income. Why? Because your home state may give you credits for the income taxes you pay other states.
Example: Someone who pays $100,000 in state income taxes over and above a large property tax bill may save $37,000 in federal taxes if they can these taxes via a pass-through-entity tax.
A third important thing to note: For state states a deadline exists for making the election. In other words, you may need to take some step such as making a payment (California) or proactively electing to use the PTET method (New York).
Despite these wrinkles, you want to talk with your tax advisor (or with us if we’re your tax advisor!) if you pay lots of state income taxes. These pass-through-entity tax elections may save you quite a bit of federal income taxes.
With that in mind, here are more details on some of the states we help clients with…
California
To elect “in” to California’s pass-through-entity tax system, you want to make a pass-through-entity tax payment by June 15 of the year you want to start using this approach. That payment needs to equal the greater of $1,000 or 50 percent of the pass-through-entity tax your pass-through entity paid in the prior year.
To make the payment you use this web page: Paying California Pass-through-Entity Tax
Note that you’ll want to make an ACH payment from your pass-through-entity. You, the shareholder or partner, don’t make the payment. The corporation or partnership or LLC taxed as a partnership or corporation does.
Illinois
We’re just going quote Illinois’ procedures from their website:
The election to pay the PTE tax is made on Form IL-1065, Partnership Replacement Tax Return, or Form IL-1120-ST, Small Business Replacement Tax Return.
When a partnership or S corporation makes the election to pay the PTE tax, it is required to make quarterly estimated payments if the expected tax due (including both PTE tax and replacement tax) is more than $500; otherwise, they will incur late estimated payment penalties.
Estimated payments are due on the 15th day of the 4th, 6th, 9th, and 12th months of the tax year. Estimated payments can be made electronically using MyTax Illinois or ACH Credit or by mail using 2022 Form IL-1065-V, Payment Voucher for Partnership Replacement Tax, or 2022 Form IL-1120-ST-V, Payment Voucher for Small Business Corporation Replacement Tax.
New York
As with some other states, New York partnerships and S Corporations pay the PTET payments using an online web payment system (log in to pay button available here.)
Pass-through-entity tax payments should be made quarterly on the April 15, June 15, September 15, and December 15. The pass-through-entity’s tax return will show these payments. The taxpayer uses his or her proportional share as a credit against the regular New York state income tax.
For 2023 and later years, entities need to affirmatively make the PTET election.
More infomration about New York’s PTET tax appears here:New York Pass-through Entity Tax
Ohio
Ohio entities may elect to pay to pay a five percent pass-through-entity tax when they file their Ohio tax return. The PTET payment creates a refundable credit.
More information is available here: Ohio Pass-through-entity Tax Workaround memo.
Oregon
Oregon pass-through-entities elect to pay the pass-through-entity tax when they file the entity return. Further, an Oregon pass-through-entity should make estimated payments of the PTE tax on the usual estimated tax payment dates. (If the business doesn’t, it owes underpayment penalties.)
You can get more detailed information here: Oregon Pass-through Entity Elective (PTE-E) Tax
Pennsylvania
Pennsylvant does not as of this writing (early 2023) provide a pass-through entity tax, though legislation is pending.
Note that this lack of a Pennsylvanit PTET means Pennsylvanis entities with income sourced to other states with PTET need to be careful. Electing to use a pass-through entity tax create a federal tax deduction but cost state tax credits.
Virginia
Virginia allows pass-through entities to calculate the pass-through entity tax on the regular entity tax return.
The PTE tax should be paid by the return deadline, again as part of the regular tax return process.
More information and links appears here: Virginia Department of Taxation website.
Washington
Because we’re located in Washington state, let us just point out that Washington in general doesn’t tax income. Thus Washington doesn’t have (and businesses operating in Washington state don’t need) a pass-through-entity tax.
Note that Washington does now levy a capital gains tax on some taxpayers, however. More information on that is available here: Washington State Capital Gains Tax Planning.
Other Resources
The IRS rules for pass-through-entity tax accounting appear here: IRS Notice 2000-75.
CrossLink Tax Software published a good overview written by CPA Mark Castro of state pass-through-entity taxes here. Lots of good links.