When it comes to taxes, partnerships and S-corporations face unique considerations. These pass-through entities generally do not pay federal income taxes at the entity level; instead, their income “passes through” to individual owners who pay tax on their share of the income. However, state and local tax (SALT) payments can add complexity to the equation. Understanding the rules for deducting these taxes is critical for proper tax planning and compliance.
SALT Deduction Basics
State and local taxes can include:
- Income taxes
- Franchise taxes
- Real and personal property taxes
- Sales and use taxes
For partnerships and S-corporations, these taxes are typically incurred at the entity level but impact the individual partners’ or shareholders’ federal tax liability.
1. Federal Deduction for State and Local Taxes at the Entity Level
Traditionally, partners and S-corporation shareholders claimed their share of SALT deductions on their individual tax returns, subject to the SALT deduction cap introduced by the Tax Cuts and Jobs Act (TCJA) of 2017. This cap limits the individual deduction for SALT to $10,000 ($5,000 for married taxpayers filing separately).
However, many states have enacted pass-through entity tax (PTET) elections, allowing partnerships and S-corporations to pay state income taxes at the entity level. By doing so, these taxes are deductible by the entity as a business expense for federal tax purposes, effectively bypassing the SALT deduction cap.
2. The Pass-Through Entity Tax (PTET) Workaround
The PTET election can provide substantial federal tax savings for owners of pass-through entities. Here’s how it works:
- The entity pays state income tax on behalf of its owners.
- The payment is deductible by the entity as an ordinary business expense, reducing its taxable income.
- The owners then receive a corresponding credit or exclusion on their state tax returns to avoid double taxation.
Important Considerations:
- PTET elections are state-specific. As of now, over 30 states have implemented some form of PTET regime.
- Timing of the election and payments is crucial to secure the deduction in the desired tax year.
- Owners should assess how the PTET interacts with their overall tax strategy, especially if they have income from multiple states.
3. Non-Income State and Local Taxes
For non-income-based state and local taxes, such as property taxes or franchise taxes, deductibility depends on their nature:
- Property Taxes: Deductible as a business expense when paid by the entity.
- Franchise Taxes: Also deductible at the entity level if they are based on income, property value, or business activity.
These deductions are not subject to the SALT cap, as they are taken directly on the entity’s federal tax return.
4. Key Implications for Partnerships and S-Corporations
- Tax Planning Opportunities: Leveraging PTET elections can reduce the overall federal tax liability for owners.
- Compliance Requirements: Owners and entities must stay up-to-date with state-specific rules and deadlines for PTET elections and payments.
- Coordination with Owners: Since SALT deductions directly impact the owners’ individual tax returns, clear communication is essential to avoid surprises.
5. Practical Example
Let’s say an S-corporation earns $500,000 in taxable income. The business operates in a state with a 5% income tax rate and offers a PTET election.
- The S-corporation elects to pay $25,000 in state income taxes on behalf of its shareholders.
- This $25,000 is deductible on the S-corporation’s federal tax return, reducing its reported income to $475,000.
- The shareholders receive a credit for the state tax paid, which they use when filing their individual state tax returns.
Without the PTET election, the shareholders would instead report the full $500,000 on their federal tax returns, with any SALT deduction subject to the $10,000 cap.
Conclusion
Understanding and optimizing the deductibility of state and local taxes for partnerships and S-corporations can significantly impact owners’ federal tax liabilities. By leveraging strategies like PTET elections and carefully managing non-income tax deductions, pass-through entities can help their owners keep more of what they earn.
If you’re a partner or shareholder in a pass-through entity, consult with a tax professional to ensure you’re making the most of your SALT deductions. At High Impact CPA, we specialize in helping businesses and their owners navigate complex tax rules to achieve maximum savings. Contact us today to learn how we can help optimize your tax strategy!
