Passthrough Entity Elections
There were numerous changes with the passage of the 2017 Tax Cuts and Jobs Act. One most notable change was the individual limitation to itemized deductions of state and local taxes. Individuals who itemized deductions and could previously deduct all real estate and state income taxes are now held to a $10,000 deduction limit. States that imposed individual income taxes were quick to take remedial action resulting in different legislative strategies. When the dust settled, and after challenges carried to the Supreme Court, what was left was an alternative for pass-through entities.
Pass-through entities, usually partnerships, LLCs, and S Corporations, are entities passing through their income and losses to the entity owners. The owners in turn report this activity on their personal return and pay any necessary taxes. Most states have now enacted legislation that would enable the entities themselves to pay state income taxes. This tax expense then becomes a deduction to the business entity lowering the overall federal taxable income passed through to owners. This enables owners of pass-through entities to still benefit from a state income tax deduction without a $10,000 cap on the deduction.
Pass-through entity owners should be cautious before jumping to make a pass-through entity tax election at the state level. This new pass-through entity level tax is implemented differently by state and a thorough analysis of the election impact should be conducted before making any entity election. While the state income tax deduction is attractive to owners, especially high earning individuals impacted by the $10,000 tax deduction limitation, making the election can cause increases to tax elsewhere (such as other state income taxes) and can lower income which in turn lowers the deduction allowed for qualified business income.
There are several questions that should be answered when considering a pass-through entity tax election. For which states does the entity and the owner have filing requirements? How will the election be administered in each state? Is the election an annual election or permanent election? What is the timeframe for making an election and are estimated tax payments required? Will the benefits of making the election (i.e., lower federal income tax) outweigh the costs (i.e., potentially higher state income taxes, lower qualified business income deduction, and increased administrative costs)? Please contact your trusted tax advisor to walk you through these questions and help with the overall analysis.