Pass-through Entity Tax

Prior to the Tax Cuts and Jobs Act of 2017 (“TCJA”), many more individuals itemized

their deductions on Schedule A of Form 1040. On the flip side, the standard

deduction was much smaller than it is now both for married filing jointly and single

taxpayers. After TCJA, the two largest itemized deductions affected were the

state and local tax deduction and the mortgage interest deduction. The state and local tax

(“SALT”) deduction moved from no cap to a cap of $10,000. In conjunction, TCJA

increased the standard deduction which causes far more people to use the standard

deduction today as a result. To combat the SALT cap, states created the pass-through

entity tax to help business owners receive a federal deduction for state taxes paid. While this option has been around for awhile for those business owners to whom it applies, there is still some mystery surrounding how it works. I'll attempt to clear up some of the confusion on why the pass-through entity tax exists.

Pass-Through Entities

For those who are unaware, pass-through entities “pass" on the income they generate

to their owners to be taxed on the owner’s return. Examples of pass-through entities are

single member LLCs, both sole proprietors and S Corporations, and partnerships.

Partnerships and S Corporations flow their income down to their owners via a Form K-1.

Both entities must file a separate informational return to tell the IRS how much income

is allocated to each owner. A partnership files Form 1065 and an S Corporation files Form

1120-S. Sole proprietors report income from their businesses on Schedule C of their

Form 1040.

State Taxes

Partnerships and S Corporations often pay state taxes on behalf of their owners and

remit those taxes to the various authorities. In exchange, owners of these entities

receive credit on their individual state tax returns for the taxes paid by the entity so as

not to be double taxed on the same income. Prior to TCJA, income taxes paid on behalf

of shareholders or partners by their entities were passed through to the owners and

taken as state and local tax deductions on the owners Schedule A of Form 1040.

There was no limit to the amount of state taxes deductions allowed via itemized

deduction, and it was a large planning tool for many business owners. TCJA capped the

state and local tax to $10,000 in 2017 creating a disadvantage for some taxpayers. In

response to the change in law and concern that businesses could flee to more tax-

advantageous or no income tax states, some states put into effect a pass-through entity

tax regime as a workaround to the SALT cap. As of mid-2024, 36 states have adopted some

form of this regime.

Pass-Through Entity Tax - How It Works

A partnership or S Corporation will calculate income for a given tax year and that

income is apportioned to various states for which the entity is required to file. Let’s

say the entity files in Virginia (my home state). The entity would pay the Virginia tax on

apportioned Virginia income for the year on behalf of its owner(s). The Virginia tax paid

would be an expense of the entity. This is expense is deductible for federal purposes

thus lowering the amount of federal income reported by and taxed to the owner(s). So,

owners of pass-through entities can now reduce their federal income by the amount of

state taxes paid as a workaround to the $10,000 cap on state and local income taxes

deductible on Schedule A of Form 1040.

"ONE BIG, Beautiful Bill"

Although the bill has not passed and its survival in Congress is less certain than once

was, the new proposed bill aims to keep the state and local tax cap in place. In addition,

the bill proposes to eliminate the ability of states to use these pass-through entity tax as

a workaround. Partners and shareholders should keep an eye on this as talks progress. If the bill does not pass, it is possible, although unlikely, the SALT cap could sunset and we would be once again able to deduct state taxes as an itemized deduction free of a cap as we did pre-2017.

CONCLUSION

If you are a partner in a partnership or own S Corporation stock, the pass-through entity tax is a great way to get additional state tax deductions you otherwise would not have been able to take if you simply itemized your deductions. You may want to check to see if your business is taking advantage of the pass-through entity tax (if applicable) while able. This workaround for the SALT cap can be provide sizable federal deductions. If you have any questions about the pass-through entity tax or other tax issues, please reach out to us at abs@westhighlandtax.com or 571-445-0501

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