Only when the TCJA was enacted did most states impose an income tax at the pass-through entity (PTE) level. A pass-through entity can deduct state taxes at the entity level for federal tax purposes.
In contrast, the entity owners can receive a credit or income exclusion for state income tax purposes. But is PTE tax deductible? What are its federal returns? Let us learn more about PTE in detail.
Is PTE Tax Deductible on Federal Returns?
The deductibility of PTE (Pass-Through Entity) tax on federal returns depends on several factors, and the answer can be both yes and no, depending on the specific circumstances.
| Scenario | PTE Tax Deductible for Individual Owners (Federal Returns) |
|---|---|
| Regular PTE payment without election | No |
| PTE tax election in applicable state | Indirectly, through reduced taxable income on K-1 |
| State-specific tax workaround program | Depends on program details and individual situation |
What Is an Elective Pass-Through Entity Tax?
A pass-through entity elective tax is assessed on the entity’s income directly, defined as the resident owners’ income plus the apportioned income of the nonresident owners.
The pass-through entity tax replaces the nonresident withholding due with PTE-100. Those who pay the pass-through entity tax must no longer file PTE-100.
Which States Enacted an Elective PTE Tax?
The pass-through entity tax (PTE) applies state income taxes to partnerships and S corporations. A pass-through entity tax is in effect in the following states:
- Alabama
- California
- Connecticut
- Idaho
- Illinois
- Louisiana
- Massachusetts
- Maryland
- Minnesota
- New Jersey
- New York
- Rhode Island
- South Carolina
- Virginia (2021-2025)
- Wisconsin
- Arkansas
- Arizona
- Colorado
- Georgia
- Kansas
- Michigan
- Mississippi
- New Mexico
- North Carolina
- Ohio
- Oklahoma
- Oregon
- Utah
- Hawaii
- Missouri
Challenges related to the PTE
According to IRS notice 2020-75, whether the deduction for PTE payments is still being determined when they are made or as accrued at the entity level is unclear. This issue is expected to be addressed in the future, along with how the entity will refund excess PTE payments in future years.
- PTE payments are generally treated the same as other tax expenses on federal returns and allocated pro-rata to owners according to ownership percentage. As a result, some partners that did not participate in PTE would still be eligible for a tax deduction.
- In S corporations, this could mean electing owners would not receive the full benefit of the higher deduction, and non-electing owners would lose their income shares. Practitioners have requested that the IRS address this issue and allow for a resolution by distributing cash to correct this inequity. It may result in a second class of stock being issued. A partnership’s operating agreement could be amended to allow for a special allocation of the PTE deduction.
- Many states allow the PTE election to be made annually on one’s original, timely filed return, including an extension. However, some states, such as California, require the election to be made before the end of the tax year if it is to be valid.
What Effect Does Pass-Through Entity Election Have?
While each of these elections differs from the other, the overall theme is to shift the state taxation of pass-through entity business income from the owner to the entity. In theory, the state tax imposed on business income would be deductible for federal purposes if the state tax is imposed at the entity level.
As a result, the owner of a pass-through entity will be taxable less. The IRS confirmed this treatment by releasing IRS Notice 2020-75 about allowing PTE tax payments to be expensed.
The overall benefit of taking these elections depends on analyzing the specific fact pattern of each taxpayer. It closely examines entity type, ownership structure, income type, owner residency, and multistate presence. Taking the election increases the tax burden in some circumstances.
How Does Pass-Through Entity Eligibility Differ Between States?
PTET regimes differ regarding who can claim PTET credit and whether it is refundable. In New York, individuals, estates, and trusts can only claim the refundable credit for taxes an entity pays. In other states, such as Illinois and Maryland, all members, including corporations and pass-through entities, may qualify for PTET credit.
Connecticut and Massachusetts imposed limits on how much PTET credit a member can claim: 87.5% and 90%, respectively. Due to the lack of conformity between states, tax professionals and taxpayers must evaluate each state individually to determine how much the PTET will benefit them.
Timing of the Election
There are different rules for each state’s enactment of PTE taxes, including timing; for example, New York requires a 2023 election by March 15, 2023, while other states require a 2024 return filing.
Timing of the Deductibility of PTE Tax Payments
Tax payments made by PTEs may be deducted at the federal entity level in computing taxable income or loss.
Generally, such payments are deductible in the year the taxes are paid or accrued; however, Notice 2020-75 specifies that the deduction is allowed “in computing taxable income for the taxable year in which the payments are made.”
It means that even if a PTE tax is registered with a timely filed return, a deduction may need to be taken that year.
What should you do?
Flow-through entity partners should inquire with the managing member or entity contact if the entity is eligible for the PTE and if an election has been made promptly.
You should ensure that any required or estimated PTE payments have been made before year-end so that you can claim the deduction on your federal tax return.
Are accrued SITPs deductible?
SITP liabilities are deductible according to the partnership’s or S corporation’s accounting method. SITPs still determine whether they must be paid or accrued for a PTE to qualify for a federal deduction.
Considering the ambiguity in the notice, one could argue that an accrual-basis taxpayer can receive a federal tax deduction for a tax liability either paid or accrued at year-end.
Depending on the state, an election to pay the SITP must be made in the year to which it pertains, while in other states, the election must be made only in the first year, making the election permanent.
Additionally, some states require the election to be filed on time on a state tax return. The recurring-item exception can only be adopted as part of a taxpayer’s accounting method in the year the item is incurred for the first time.
Conclusion
The election of PTE taxes may allow PTE owners to save substantial federal income taxes while complying with all state tax obligations.
PTE taxes vary between states, and PTE structure and ownership must also be considered when determining if to elect into a state’s PTE tax. Before electing any individual PTE tax, a PTE must consider the combined federal and state tax consequences. Check out Beem to file your federal and state taxes without any hidden charges and get the maximum refund
FAQs
Regarding federal income taxes, what is deductible?
Mortgage interest, retirement plan contributions, HSA payments, student loan interest, charity donations, dental and medical expenditures, lost gaming profits, and state and local taxes are a few of the more popular deductions.
Can I deduct CA PTE from my federal taxes?
If the PTE tax is elected and paid, the entity’s federal return will show a tax deduction, lowering the taxable income shown on the owners’ and partners’ federal K1 forms.
Is there a return for PTE costs?
50% of the PTE test price will be partially refunded to candidates who cancel the exam fewer than 14 calendar days but at least seven days before the test date. But only if applicants canceled the exam at least seven calendar days in advance would they be eligible for a refund.
