The Tax Cuts and Jobs Act of 2017 (“TCJA”) made significant changes to the tax code. For individuals, the TCJA put in place a $10,000 federal deduction limit for state and local taxes. This limit is costly for individual tax filers who itemize deductions and cannot claim more than $10,000 for property and state income taxes.
While blocking some individual strategies to bypass this cap, the IRS has issued guidance allowing for pass-through entities (“PTEs”), such as partnerships, S-corporations, and LLCs, to deduct state taxes at the entity level, creating a workaround to the $10,000 limit. Since the issuance of this guidance, a growing number of states have passed legislation to approve the workaround.
Each state has its own unique rules regarding PTE taxes, including who it applies to, the applicable tax rate(s), estimated taxes, and by when a taxpayer needs to make this election. While many states allow for the election to be made by the original filing due date of the PTE tax return (March 15, 2022 for 2021 tax return filings), other states have diverged from this date. In particular, for the 2021 tax year, New York is requiring taxpayers to make this election by October 15, 2021. Taxpayers must check the deadlines for the states that apply to them.
While there are many considerations in determining whether to elect a state PTE level tax, generally speaking, PTEs that are reporting taxable income (or who expect to report income or gains) which flows to partners who are taxpayers affected by the $10,000 federal deduction limit should consider whether to avail themselves of any applicable state PTE level taxes. Additionally, if a PTE determines it should utilize a state PTE level tax, then it should further consider whether the deductions relating to the applicable state taxes should be specially allocated to certain partners, and whether the partnership agreement must be amended to allow for such special allocations.
Taxpayers should also consider the compliance burden in electing a state PTE level tax. Depending upon the state, an individual partner may still have an obligation to file an individual tax return in a state where a PTE level tax is elected and paid. Additionally, PTE level taxes paid in one state may not be creditable in another state, including one’s home state. Taxpayers need to consider the effects of making a state PTE level tax election in totality with all other federal, state and local filing requirements.
Taxpayers need to be aware that this area of tax is dynamic and changing. Regulations are still forthcoming from the IRS that could affect the overall federal tax treatment of any state PTE level taxes. Additionally, there are active discussions occurring on Capitol Hill as to a repeal of the limitation on state and local taxes. The timing and effect of any such change in the tax code is uncertain.
Ultimately, the decision to elect a state PTE level tax will affect an individual partner’s income tax return. Any partner(s) considering such an election should consult with his or her personal income tax representative.
Please contact your DOZ professional if you have any questions.