kim rueben is the director of the State and Local Finance Initiative at the Urban-Brookings Tax Policy Center. This article is adapted from the Tax Policy Center’s TaxVox blog.
Published August 12, 2021
In June, Colorado became the 14th state to either require or allow some “pass-through” businesses such as partnerships to pay state income taxes at the business level rather than on the owners’ personal income tax returns.
Why (even if you’re not a tax code geek) should you care? Because it’s an increasingly popular way for states to give some residents relief from the 2017 Tax Cuts and Jobs Act’s (TCJA) $10,000 cap on the state and local tax (SALT) deduction without lowering state revenue by a dime.
As soon as the SALT cap became law, states with substantial income taxes (most of which are blue) started to look for workarounds. The U.S. Treasury disallowed others, but not this one. The key difference is that the SALT cap in the TCJA applies only to personal income taxes, not to taxes paid by businesses. Thus, business owners can deduct state income taxes without limitation if the taxes are paid at the business level.
Remember that, for tax purposes, there are different types of businesses — C corporations and pass-through businesses such as sole proprietorships, partnerships and S corporations. What separates them is not their size but the type of business tax they pay.
Only C corps pay federal corporate income tax. The vast majority of businesses are pass-throughs that typically pay their federal tax on earnings via their owners’ federal personal income tax. That is, their earnings traditionally are passed-through to owners’ personal tax returns. But here is the states’ innovation: if state income tax is paid by the pass-through business at the entity level rather than on the owner’s individual state income tax return, the Treasury says the SALT cap does not apply. That’s why many states are changing the traditional business tax equation and introducing a “pass-through entity” (PTE) tax.
In some states, including New Jersey, business owners get a credit for their share of the tax. In others (like Louisiana) the owners’ state taxable income is reduced by the income included on the pass-through’s return. The formal IRS guidance makes no distinction between Connecticut’s mandatory PTE tax and the voluntary levies in 13 other states.
Since corporations already can deduct income taxes against their receipts, it could be seen as equalizing treatment of the SALT deduction across different types of businesses. But PTE taxes create inequities based on type of income.
Here’s how it works in New York: any partnership or S corporation may pay the tax on New York state income. The tax is imposed on the share of profits to individual (not corporate) investors. And it has a graduated rate depending on income. Business owners then claim a credit against their individual income tax based on their share of PTE taxes. New York also allows credit for New York residents who might have PTE credits from other states.
The IRS guidance, it’s worth noting, applies only to income taxes. Business owners are still subject to the SALT deduction limit for state property taxes and state income taxes on their wages. Moreover, to be eligible, a business must have at least two owners. Thus, sole proprietorships are out of luck.
Leveling the Playing Field?
Crucial to the states: while these new entity-level taxes can save business owners substantial federal taxes, the states still collect the same amount of income tax on these business earnings. Only federal tax liability declines. That makes the states (and a lot of taxpayers) happy. But is this good public policy?
Since corporations already can deduct income taxes against their receipts, it could be seen as equalizing treatment of the SALT deduction across different types of businesses. But PTE taxes create inequities based on type of income. For example, because these states now favor pass-through income over wages, a partner in a law firm is effectively exempt from the SALT cap while an executive assistant or associate who is employed by the same firm remains subject to the deduction limitation. A doctor who is an employee of a corporation is barred from fully deducting state and local income taxes while a partner in a medical practice making the same income is exempt from the federal cap for these taxes.
Because the workarounds differ across states, businesses need to consider where partners live and where business income is generated. For example, nonresident partners might not benefit from the credits in their home state. Like New York, some states of residence allow credits against the taxes these partners owe from other states. But that isn’t always the case.
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These PTE taxes may prove to be just a temporary fix – Congress may consider changes to the SALT cap in coming legislation. In any event, the cap, along with all other individual tax changes in the 2017 tax act, is scheduled to expire at the end of 2025. Still, the entity-level tax workaround is likely to become increasingly popular. While it makes state taxes more complicated, it helps high-income residents reduce federal taxes at no cost to the states themselves.
What a deal.