State Pass-Through Entity Taxes (PTET) - The Effect on Tiered Partnerships and Investment Partnerships
By: Allen Schaefer, CPA, MBA
New York, NY — July 6, 2022
Many taxpayers may now have an opportunity to deduct incurred state and local income taxes (SALT) through workarounds referred to as pass-through entity taxes (PTET) that attempts to shift the liability for income taxes from pass-through entity (PTE) owners to the PTE itself. This opportunity is a result of newly passed state legislation that allow a PTE to pay state-level taxes on income – and claim a corresponding federal deduction – which in turn permits affected individual PTE owners to maximize their eligible deduction that would otherwise be bound by the SALT cap of $10,000 ($5,000, if married filing separately). In this article, we will explore how electing into a state’s PTET regime could significantly help PTE business owners indirectly reduce their overall tax burden and examine the PTE tax benefits and risks of Tiered Partnership and Investment Partnership structures.
State PTE Taxes
As mentioned in our previous PW Tax Alerts, the intent of enacting a PTET is to allow PTEs such as partnerships, LLCs taxed as partnerships, and S corporations to pay taxes at the entity level (as opposed to the individual level) as a workaround to the state and local income tax (SALT) limitation of $10,000 ($5,000, if married filing separately) imposed by the Tax Cuts and Jobs Act (TCJA) of 2017 under Internal Revenue Code (IRC) Section 164(a). Following TCJA, most states including California and New York, both of which have seen large population outflows in recent years due in part to each’s increasingly high tax burden and cost of living, enacted legislation allowing for PTET elections. In 2018, Connecticut opted for a mandatory tax while the rest of the states opted for an elective tax. At the PTE owner’s level, some states provide for a full or partial tax credit while others provide for an income exclusion. Further some states provide a resident partner with a state tax credit, subject to limitations, for their share of PTET paid to another jurisdiction while others do not. While the states have issued guidance, there are many questions left unanswered. Before making a PTET election, it’s important to realize that the eligibility requirements, election procedures, and tax effects as each state is unique.
As of this writing, the following twenty-seven states (and one locality) have enacted an elective PTET (unless denoted otherwise) since TCJA’s SALT deduction limitation took effect:
Tax Planning Opportunity for Tiered Partnerships and Investment Partnerships
As a taxpayer and as an investor, one should be mindful of the tax and nontax attributes associated with Tiered Partnerships and Investment Partnerships. Like Tiered Partnerships and Investment Partnerships, a husband-and-wife partnership may be eligible under state law to elect into a state’s PTE regime. However, from a federal tax deductibility perspective, the question then becomes, is it a good idea for high-income earners to create a husband-and-wife partnership, contribute money and investment assets into the partnership and make a PTET election to achieve indirect tax benefits for which they would not otherwise be eligible for? Leaving aside estate tax planning considerations, at first glance, this seems like a strategy worth exploring. Like a good dentist, let’s continue to keep drilling away at every cavity and explore this further by looking at the following example:
Assume that husband-and-wife form an investment partnership and contribute $100 million of investment assets. Husband and wife are New York resident partners and share in the partnership’s profits equally.
The investment partnership earned $10 million, taxed as STCG and not subject to state sourcing.
The partnership is eligible to elect into the New York PTE Tax.
For the moment, let’s assume that New York PTE Taxes paid is fully deductible by the partnership as a nonseparately stated item on its federal tax return. Note: please see Risks and Uncertainty for additional tax caveats.
For simplicity, let’s assume that both the New York PTE tax rate and the partners’ New York individual income tax rate is 10%. The federal tax rate is 40.8% (top rate of 37% plus the NIIT of 3.8%).
For federal and state individual income taxes, husband and wife file married filing jointly returns.
Scenario #1: If no PTE election is made, then husband and wife will receive profits of $10 million, in aggregate, and pay New York personal income taxes of $1 million ($10 million * 10%). Assuming they take the itemize deduction, due to the SALT limitation, they will only be able to claim a $10,000 federal itemized deduction and pay federal income taxes of $4,075,920 (40.8% * ($10m - $10k)). In aggregate, federal and state income taxes paid equals $5,075,920.
Scenario #2: If a PTE election is made, then the PTE will pay New York taxes of $1 million ($10 million * 10%) to which husband and wife will receive a full refundable state personal income tax credit. The PTE will issue K1s to the husband and wife and report a distributive share of income for $9 million ($10m - $1 million). Husband and wife will report New York personal income taxes of $1 million which will be fully offset by the received PTE tax credit. Husband and wife will pay federal income taxes of $3,672,000 (40.8% * $9m). In aggregate, federal and state income taxes paid equals $4,672,000.
Compared with Scenario #1, Scenario #2 provides a potential net tax savings, in the aggregate, of $403,920 ($5,075,920 less $4,672,000) due to PTE taxes being borne by the investment partnership and not the husband and wife directly.
IRS Notice 2020-75
With respect to PTEs that operate a trade or business, IRS Notice 2020-75, released on November 9, 2020, provided clarity needed to deduct state and local income taxes as a nonseparately stated item, at the PTE level, made to jurisdictions described in IRC Section 164(b)(2) and circumvent the $10,000 SALT limitation, as enacted by TCJA. However, it was uncertain whether the same would hold true in the case of Tiered Partnerships and Investment Partnerships that are generally subject to the miscellaneous itemized deduction limitation rules and would report expenses as a separately stated item, under IRC Section 212, subject to the SALT limitation. Further the notice indicates that the IRS and Treasury intend to issue proposed regulations to clarify that state and local income taxes imposed on and paid by a PTE on its income are allowed as a deduction in computing its nonseparately stated income or loss and therefore are not subject to the SALT limitation for affected owners who itemize deductions.
Risks and Uncertainty
While a PTE that’s engaged in a trade or business (within the meaning of IRC Section 162) is generally allowed to claim the PTE Tax as a nonseparately stated federal deduction (under IRC Section 164) provided that the expense is paid or incurred in carrying a trade or business, the same may not be true in the case of Tiered Partnerships and Investment Partnerships that are subject to the miscellaneous itemized deduction limitation rules and would report such as a separately stated item (under IRC 212). Consequentially, in some cases, the tradeoff is the deductibility of some entity-level expenses which may be limited by the itemized deduction phase-out provisions or added back entirely under the AMT at the owner’s level. As mentioned in a previous PW Alert dated July 16, 2021, it is not clear that Investment Partnerships will benefit by participating in the PTET program. Generally, investment related expenses are no longer deductible as an itemized deduction. (Prior to 2018, they were deductible to the extent in excess of two percent of AGI.) Furthermore, losses may be disallowed in the current year if one is subject to the passive activity loss (PAL) limitation rules.
When considering whether or not to have Tiered Partnerships and Investment Partnerships elect into a state’s PTE regime, one would need to look to the definition of trade or business to assist in ascertaining the federal tax treatment. The term trade or business generally includes any activity carried on for the production of income from selling goods or performing services. When determining whether a Tiered Partnership or Investment Partnership meets the trade or business standard one would need to look beyond the Internal Revenue Code and the Treasury regulations and obtain further guidance from existing case law. In the matter of Groetzinger, 480 U.S. 23 (1987), a case that involved a full-time gambler who made wagers solely for his own account, the U.S. Supreme Court held that a specific test is not appropriate to determine qualification as a trade or business. Rather, the issue requires an examination of the facts in each case. The Court further held that “the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer's primary purpose for engaging in the activity must be for income or profit” and that the taxpayer is engaged in a "trade or business" within the meaning of Code §§ 162(a) and 62(1).
For individual owners of Tiered Partnerships and Investment Partnerships, within the tax community there are differences of opinion on where geographically the federal deduction for PTE taxes gets reported, either as a (1) nonseparately stated item on page 1 of Federal Form 1065 (for partnerships and LLCs taxed as partnerships) or Form 1120S (for S Corps) or (2) as a separately stated item on Schedule K. For method (1), affected individual PTE owners would indirectly receive an uncapped federal tax deduction before the income is passed through to them on the K1. This is generally the more tax beneficial method. However, for method (2), affected individual PTE owners would not receive an uncapped indirect federal tax deduction. Rather they would likely report such as either an itemized deduction on Federal Form 1040, Schedule A that is (potentially) subject to AMT inclusion or on Schedule E not subject to the AMT.
In 2021, former IRS Chief Counsel Michael J. Desmond provided some thoughts that may shed light into how the IRS may be approaching the husband-wife partnership planning idea as mentioned earlier. “In the context of the entity-level tax, you get quickly into some more complicated substance-over-form issues”, Desmond said. He further stated that “setting up something that isn’t a partnership doesn’t get you the benefits of the Partnership”. “And there’s certainly opportunity for the IRS to challenge those structures in egregious cases.”
The tax community has been anxiously waiting for further clarification, however, the to-be-announced forthcoming regulations as prescribed in Notice 2020-75 haven’t been released, and so it’s currently up to practitioners to interpret existing tax rules and regulations on how best to navigate the murky PTET waters and best advise clients.
When considering making a PTE election, know this is a complicated tax strategy and may require consulting with a Perelson Weiner tax professional.
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