2023 Marcum Year-End Tax Guide

THE MARCUM YEAR-END TAX GUIDE 2023 85

to offset the passive deduction, the PTET deduction gets suspended and carried over to a future year until that investor either reports enough passive income to absorb the passive loss, disposes of their interest in the entity or…dies. As is often the case, there are timing differences between the PTET credit claimed on that state’s return and the PTET deduction. The credit is claimed based on the entity’s payments, including those made in the following year, such as those for the fourth quarter or even those made with the extension. In contrast, the federal deduction for a cash basis entity taxpayer would strictly include the payments made before the entity year-end. Additional consideration should be given to the interplay between passive activity loss rules, timing of the federal deduction, and state add-backs, especially when income is expected to swing significantly from year-to-year. When it comes to trusts, irrevocable grantor and non-grantor trusts should consider the impact of making a pass-through entity (PTE) state income tax election. For instance, in certain states, only grantor trusts can pass the PTET credit to the beneficiary, whereas other types of trusts retain the credit at the trust level.

A benefit of irrevocable grantor trusts is that the trust can grow unburdened by income taxes because the grantor pays the income tax liability on the trust’s income. The payment of the trust’s income tax liability by the grantor further reduces the grantor’s taxable estate and is not considered a gift to the trust, provided that the requirements of Rev. Rul. 2004-64 are met. When an irrevocable grantor trust makes a PTE state income tax election, the state income taxes are paid by the PTE on the trust’s share of state income. If the tax liability is shifted to the entity level, the trust ultimately bears the tax cost, not the grantor. Thus, the estate and gift tax benefit of the grantor paying the state income tax on the trust’s PTE state income is lost when the PTE state income tax election is made. We think reimbursing the trust for state income tax paid due to the PTE state income tax election would be deemed a taxable gift. However, there is no guidance from the IRS on this issue. Many states have issued guidance for non-grantor trusts that make a PTE state income tax election. Some states have specified the credit for state income tax paid is available only to the trust and not to the beneficiary. Some states do not allow trusts to make the PTET election altogether.

In those states where trusts are allowed to make the PTET election, non-grantor trusts that distribute all the trust’s distributable net income to beneficiaries can lose the benefit of the PTE state income tax election in certain states if the credit is not refundable. Some states allow for a carryforward of the credit; however, if the trust regularly distributes or is required to distribute income every year, the benefit of the PTE state income tax election would likely be lost. Each of the 36 states that have adopted different versions of the PTET, and the computation mechanics can be quite intricate. Some states allow overpayments to be credited, whereas others mandate overpayments be refunded. PTET deduction is a powerful new tax planning tool, and the Marcum SALT team has the instruction manual.

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