In 2018, the Tax Cuts and Jobs Act (TCJA) was enacted. As part of the revised provisions, the IRS limited the deductibility of state and local tax (SALT) payments as an itemized deduction for federal income tax purposes to $10,000 in a calendar year. This limitation has generally increased taxes due to the federal government for many individuals.

As taxes increase, taxpayers generally look to find ways to mitigate taxes, including tax planning opportunities that potentially reduce state income taxes. States with high income tax rates, such as New York, New Jersey, and California, could potentially be impacted most by this SALT deduction limitation, as individuals could consider abandoning their domicile and/or residency in many of these states to reduce their personal income tax burdens.

To help their residents and protect state revenue, many states have adopted and enacted legislation implementing a pass-through entity tax (PET). Historically, a pass-through entity (PTE) is not subject to income taxes; its members are taxed instead. However, by implementing a tax on a PTE, the objective is to be able to take a deduction for the taxes paid by the PTE on the PTE’s federal tax return. In turn, the income flowing from the PTE to its members would decrease by the PET deduction; thus, the member’s federal income tax burden would be lower.

Initially, there has been concern about whether such taxes paid by a PTE would be deductible as an expense for federal income tax purposes. However, IRS Notice 2020-75 put many of those concerns to rest, as the notice provides informal acceptance of a PET regime. Though there are still some concerns related to deductibility, many states have used Notice 2020-75 as a catalyst to enact their versions of a PTE tax. Approximately 20 states have now adopted PET legislation, including New York State, which passed its version earlier this year.

Like any new legislation, these new PTE taxes, which in most of the enacting states are elective, come with many risks and planning opportunities. First, all taxpayers should review risks from an overall federal or entity-level perspective. Some of these implications include making sure both the PTE and its members understand the impact of making a PET election in a specific state; addressing how ineligible members should be handled; the cash impact to partners; and whether the partnership agreement properly addresses special allocations for this type of expense. These considerations are more complex for a larger PTE that has more diversified members and will be easier for a smaller, closely held PTE.

Aside from federal or entity-level risks, there are many state implications and considerations that each PTE and its members should review with their tax advisors, some of which are discussed below.

• Making an election. Each applicable state should be reviewed to confirm when the election is due, whether it is revocable or irrevocable, and who is authorized to make the election. In addition, each state should also be reviewed to see whether the election is binding to all members or whether there is an ability for a member to make an “opt-out” election. For example, California allows members to opt out.
• Filing returns. Each applicable state should be reviewed to confirm what returns are required to be filed. Some states will require a separate PET return, while other states may include the PET as a worksheet as part of the current partnership return. All states will still require a resident personal income tax return to be filed. For nonresidents, the state should be reviewed to confirm whether the PET return or a composite filing will satisfy the individual’s filing obligation. Lastly, as it relates to composite returns, each applicable state should be reviewed to confirm whether a composite return is allowed if a PET election is made. If a state no longer allows a composite return, this may change the PTE’s filing requirements and each nonresident individual’s filing requirements.
• Treatment of PET paid. Each state should be reviewed to confirm how the PTE income is treated and whether a “PET paid” credit is available to each member for taxes the PTE paid on its income. Furthermore, each state should be reviewed to determine whether the credit is refundable or nonrefundable. For example, California’s PET paid is a nonrefundable credit, but can be carried forward for five years. Connecticut’s PET paid is a refundable credit, but only up to 87.5%.
• Resident credit. Most importantly, each member’s resident state should be reviewed to confirm whether a resident credit will be allowed for PET paid to other jurisdictions. Most states that have enacted a PET will generally provide rules related to the allowance of a resident credit for taxes that are paid by a PET on the individual’s income. However, states that have not enacted a PET may not have such guidance. For example, Virginia and Maine do not allow a resident individual a credit for PET taxes that are paid on the individual’s behalf by the PTE; thus, if you have a resident individual who lives in a state with these restrictions, there is no resident credit available, which can result in double taxation.
• Computation of taxable income. Each state should also be reviewed to confirm its definition of taxable income. States can have varying definitions of what can and cannot be included as part of taxability. For example, New York State has different rules for what is included as taxable income for partnerships, rather than for S corporations. In addition, New York State also differentiates between taxable income for resident vs. nonresident individuals of a partnership. 
• Payments required. In many states, an individual and PTE may be required to pay in more tax than is due. Thus, each individual and PTE will need to review its cash flow concerns and consider the time value of money as well. For example, New Jersey requires an electing PTE to make not only PET estimated payments, but nonresident withholding tax payments as well. Individuals that make estimated payments will also have to address any differences in tax rates, taxable income amounts, and other impacts at their personal level.

Lastly, although there are many risks to consider, a business should also review any tax planning opportunities. For example, the PET legislation in most states excludes single-member limited liability companies or sole proprietors from making a PET election. Businesses with such structures can consider and discuss with their legal counsel and tax advisors whether there is a business reason to transition to being a multi-member limited liability company and take advantage of the benefits of making a PET election.

Although the PET has been enacted by many states as a reprieve from the federal SALT deduction limitation, such legislation comes with its own challenges. The decision to make an election may not be easy, but working with tax advisors to help make a decision may be worth it for some PTEs and can provide some significant savings to their members.