If you are considering making a PTET election effective for 2022, there are some key year-end considerations to think about right now.
In 2017, Congress passed the Tax Cuts and Jobs Act, limiting an individual’s federal deduction for state and local taxes. In response, states have enacted elections, known as Pass Through Entity Tax (PTET) elections, creating an entity level tax on partnerships and S corporations (generally Pass Through Entities, or PTEs). These PTETs can be fully deductible at the entity level (thus avoiding the limitation on the state and local tax deduction).
As of today, 29 states and New York City have passed legislation allowing taxpayers to pay taxes at the entity level. Connecticut’s tax, in particular, is mandatory. Many of these elections became effective in 2022 and all require some year-end attention from taxpayers who intend to make an election effective in this tax year.
In November of 2020, the IRS issued Notice 2020-75, announcing its intent to promulgate regulations clarifying the deductibility of payments by partnerships and S corporations for state and local income taxes. However, because the limitation on state and local tax deductions is set to sunset in 2025, further guidance does not appear to be a top priority for the IRS, meaning taxpayers may lack further clarity on many issues. For instance, it is currently unclear whether a PTE with purely investment activities can elect to pay a PTET and claim an ordinary deduction on its federal income tax return.
All PTEs making a PTET election should estimate and pay their 2022 PTET liabilities prior to the tax year-end. Specifically:
Regardless of the PTE’s accounting method, there are two additional reasons why PTEs should make all 2022 PTET payments before year-end. First, nearly all state PTETs have estimated payment provisions with penalties for underpayment. Second, while possibly not the intent, a plain reading of IRS Notice 2020-75 suggests payments are required to be made during the election year to qualify for deduction, no matter the method of accounting.
While most 2022 elections are made on returns when filed in 2023, PTEs must effectively decide whether they intend to make elections immediately. Time should be allowed for obtaining owner consent, determining qualification status, analyzing federal and state tax issues, and calculating an accurate estimate of 2002 PTET liability.
For accrual basis taxpayers there is some uncertainty about whether the deduction will be allowed during the 2022 year. Taxes are considered a “payment liability” under the economic performance rules, meaning payment is generally required before the deduction may be claimed.
However, an accrual basis taxpayer can only deduct a liability that is “fixed and determinable” at the end of the tax year. In most states, the PTET election is made on the tax return filed at either the original or the extended due date for the tax return. If the election is made at that time in 2023, there is risk that the IRS will not consider the PTET liability to be fixed for 2022.
The IRS has not issued guidance on this matter and is unlikely to do so before the end of tax year 2022. Therefore, there is inherent risk for accrual basis taxpayers that payments made during 2022 may not be deductible in 2022.
We advise accrual basis taxpayers to both make all estimated payments prior to the end of 2022 and take all actions that are possible to fix the PTET liability in 2022. Wherever possible, we recommend you file the PTET election before the end of the year.
PTEs considering 2022 elections should immediately estimate PTET liabilities for 2022. This is important to determine payment amounts and ensure the full deductibility of the PTET on the 2022 federal tax return. In addition, it is important to accurately calculate the estimate in order to minimize estimated payment underpayment penalties at the PTE level, which may already be applicable if payments have not been made during the year. Accurately estimating the liability is also important to reduce the risk of overpayment at the PTE level resulting in refunds that can be difficult to obtain.
When making an election, it is important to clarify any effect of the PTET election on owner estimated payments and nonresident withholding requirements. In some states, owners must continue making estimated payments, and/or entities must continue withholding for nonresidents. In some cases, the PTE will need to continue making composite payments in addition to PTET estimates due to the state’s inability to transfer estimated payments between the two accounts (this is true in California and may be true in other states as well).
Here is more information in select states.
As noted, PTEs must effectively decide whether they are going to make a 2022 PTE election prior to the 2022 year-end. Accordingly, PTEs and their owners must immediately analyze the benefits, risks, and planning considerations, in order to be able to accurately estimate and make payments by year end.
Some of the other material considerations PTEs should consider include:
Considering a PTET election?
Eide Bailly can help analyze if an election would be beneficial, determine how and when to make estimated payments and identify any other issues that may arise.
This article is provided for general informational purposes only. It is not legal, accounting or other professional advice, as it does not address any individual facts, circumstances or concerns. Before making personal or business related decisions, please consult with appropriate legal, accounting or other qualified professionals.
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