Pass-Through Entity Tax Deduction

By Jason Watson, CPA

Posted Wednesday, February 21, 2024

As you consider your tax planning strategies this year, please be aware that you might live in a state that has a pass-through entity tax (PTET) on the books for 2023. Why do you care? Well, it could provide you increased federal tax savings. Keep reading if you dare-

Way back in 2017, the Tax Cuts and Jobs Act was passed with a lot of cool tax deductions like the Section 199A qualified business income deduction. But life is one big equalizer, and Congress wanted to limit state and local taxes (SALT) to $10,000. This means either state income taxes or real estate taxes, or both, were severely muted. People in South Dakota owning a $600,000 house were like “what’s the big deal?!” People living in Oregon (second highest state income tax rate next to California) owning the same house were like “WTF, over?!”

So! States got creative and created a state tax that was deducted on partnerships and S corporations (otherwise called pass-through entities… or PTE if you are a cool kid) resulting in lower federal taxable income. This tax, paid by the PTE, was then credited on the business owner’s state income tax return. This also called the great SALT work-around.

Cash is cash to a business owner whether it is spent by the business or the human.

There are all kinds of rules, and not every business owner will benefit from the PTET deduction. As such, the tax planning for determining the efficacy of using this tax deduction is challenging.

For those of you who are saying “Woah” this is news to me. Here are the nuts and bolts-

1. The state has determined a percentage to be used. For example, in California it is 9.3%.
2. This percentage is multiplied by the net ordinary income (profit) of the business. So, quick math… $100,000 in profit means $9,300 PTET payment to California (as an example) made by the business.
3. This $9,300 is a federal tax deduction on your business (but it is also added back to the state). As such, you might have a $90,700 taxable profit to the IRS but $100,000 to California.
4. Figure how much of your state income tax bill is not deductible on your Schedule A of your 1040. Compare that to the $9,300 (again, our current example). Multiply that by your marginal tax rate. Let’s say all of the $9,300 is benefiting you, and you are in the 32% marginal tax bracket… you just saved $2,383 in taxes (cash). Yay! There is a also small reduction in the qualified business income deduction (so… the math is 9,300 x 0.80 x 0.32).
5. Wait! There’s more. This $9,300 is also detailed on your K-1 from the business, and it flows through to your state tax return, and it is credited (like an estimated tax payment) against your state income tax.

Bottomline is this- does it feel better to pay your state income tax with personal dollars or business dollars? It’s a bit rhetorical… no need to say it out loud or call us. Additionally, the IRS has released Notice 2020-75 which summarizes the behind the scenes tax deduction if you can’t get enough.

As Led Zeppelin once sang, Not all that glitters is gold. The pass-through entity tax deduction is one of those things. Here is a quickie list of problem states-

• California- you must have made at least a $1,000 payment by June 15 of the previous year to enroll. So, if you are working on 2023 tax returns in 2024, you needed to have made at least a $1,000 payment last year. So… no retro.
• Colorado- these clowns have screwed up PTET to the point where only a narrow body of business owners benefit. It depends on your income and if you are deemed a specified service trade or business.
• Michigan- irrevocable for 3 years like the roach motel.
• New York- must enroll in the current year using some online system completely separate from your tax returns.
• Oklahoma- must enroll by March 15 of the tax year. So, must enroll by March 15, 2024 for 2024 tax returns.
• Utah- must enroll by end of the year. So, not as bad as Oklahoma but a bit friendlier than California.
• Wisconsin- my home state is terrible. They deduct the business income away from your overall Wisconsin income. So, if you have low salaries (which is your goal in an S Corp), the savings disappear or even in some cases becomes a higher tax bill. In other words, you need non-business income to be higher (ie, salaries, other household income) so it makes sense. Wisconsin is definitely a “usually not” state.

There are other states with issues, and as you can see some of this stuff is tricky.

Other general pitfalls are-

1. Some states charge massive underpayment penalties if payments are not paid on time.
2. Some states will not refund excess payments, but rather roll them forward to future years.
3. Some states have a clunky online enrollment / election system that is separate from what we can do on a tax return.
4. Most estimated tax payment schedules include a payment in the next year. For example, PTET payments for 2024 will have a 2025 payment for Q4 or the second half of the year. Make all payments in 2024 to maximize your PTET deduction in the current year if your business uses cash-based accounting.

Jason Watson, CPA is a Senior Partner of WCG CPAs & Advisors, a business consultation and tax preparation CPA firm located in Colorado Springs, and is the author of Taxpayer’s Comprehensive Guide on LLC’s and S Corps which is available online and from mostly average retailers.