2023 Marcum Year-End Tax Guide

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As of May 31, 2023, various forms of pass-through entity tax laws have been adopted in 36 states and one locality (New York City). For many taxpayers, the mechanisms and benefits of these relatively new provisions are not fully understood. DECODING PTET: THE IRS-APPROVED SALT DEDUCTION WORKAROUND FOR PASS-THROUGH ENTITIES BY LOREDANA SCARLAT, SAMUEL SAUNDERS

Since passing the Tax Cuts and Jobs Act, P.L. 115-97, which limited individual deductions for state and local income to $10,000, taxpayers and their advisors have sought various workarounds to overcome this limitation. Although many of these past initiatives have not been successful, pass-through entity tax provisions have received the much-desired IRS nod. In Notice 2020-75, the IRS specified that the payment of a PTET to domestic jurisdiction is deductible in computing the entity’s nonseparately stated income or loss without this deduction being subject to the $10,000 cap. BACKGROUND Generally, pass-through entities do not pay taxes at the entity level. Instead, as the name indicates, entities such as partnerships, LLCs, or S corporations “pass-through” all items of income, gain, deductions, credits, and losses to their partners/ shareholders, who then report all these items and pay the associated tax on their personal tax returns. A PTET changes this approach by allowing the entity to elect to compute and pay the state tax on its income directly. The amount of state tax paid becomes a deduction

reducing ordinary income for federal income tax purposes, very much in the same way local taxes or payroll taxes offset ordinary income. By lowering the ordinary income, the respective shareholders/partners report less pass-through income on their federal tax returns, effectively deducting the state income taxes, which would otherwise be limited. WHO DOES THE PTET BENEFIT? Operating pass-through business (LP, LLC, S corporation) that ‘resides’ in a high-tax jurisdiction or whose members reside in high tax jurisdictions should definitely consider the benefits of a PTET election. It is worth noting the election is made at the entity level and not at the partner level, so advance coordination and attention to this individual benefit is needed. Managing members must examine the opportunity well in advance of compliance season. Even if the entity does not ‘reside’ in high-income tax jurisdiction, the PTET may still be tax advantageous if the entity anticipates allocating income to a high-tax jurisdiction (an example would be a Texas-based entity with income sourced in New York).

IS THE PTET A GOOD OPTION FOR EVERYONE? The answer is: it depends. Whereas the benefits of PTET are evident for operating businesses and their active members, the answer is not as straightforward when considering certain members that are inherently passive, such as trusts or various investors in investment partnerships (family limited partnerships, in particular). PTET FOR INDIVIDUAL PASSIVE INVESTORS AND TRUSTS The PTET is a deduction taken at the Federal level against ordinary income and as a credit at the state level. One particular trait of investment partnerships is that they do not generate large amounts of ordinary income. As such, it would not be uncommon to see an investment partnership report the PTET deduction as its sole ordinary income deduction or for the PTET deduction to exceed any ordinary income, thus generating an ordinary loss. This would not be an issue for an investor who is also actively involved in managing the fund. However, for a passive investor, this deduction is deemed as a passive deduction that can only be offset by passive income. If that investor does not have enough passive income