If you are considering making a PTET election effective for 2022, there are some key year-end considerations to think about right now.
What is a PTET Election?
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.
2022 PTET Payments Required before Year-End
All PTEs making a PTET election should estimate and pay their 2022 PTET liabilities prior to the tax year-end. Specifically:
- Cash basis PTEs must make payments during 2022 to claim the state tax deduction on their 2022 return.
- Accrual basis PTEs are likewise advised to make all payments during 2022 since state taxes are generally a payment liability and deductible when paid. A possible exception would be for accrual basis taxpayers adopting the “recurring item exception” on their 2022 return. Learn more about what this could mean for you.
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.
Special Considerations for Accrual Basis Taxpayers
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.
- Alabama, Arkansas, Colorado, Louisiana, and New Jersey all have mechanisms enabling a PTET election to be filed prior to the actual due date for the election.
- Arizona, Mississippi and Missouri may also provide a mechanism to make an early election but forms for making the election have not yet been published as of the date of this article.
- In states that have no means of making the election during 2022, PTEs can consider executing a Board Resolution or similar document indicating a binding intent to make the election.
Estimates and Making PTET Payments
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).
Notable State Specific Year-End Considerations
Here is more information in select states.
- Utah: During the 2022 legislative session, Utah adopted a new PTET first applicable in 2022. The Utah PTET has some unique features, including a requirement that the entire PTET liability be paid prior to the end of the 2022 tax year. Under the Utah statute, the payment of the liability constitutes a binding PTET election for the 2022 year. Accordingly, Utah is among the few states requiring the election to be made during the 2022 tax year. While accelerating the timeframe for the election, this requirement causes PTET liability to be fixed during 2022 and avoids the issues for accrual basis taxpayers noted above. The Utah DOR recently released a new Form TC-75 and web portal to make payments and the election.
- Alabama, Arkansas, Colorado, Louisiana, New Jersey, Virginia: These are states that optionally allow PTEs to make elections prior to the end of the tax year. Accrual-basis PTEs who plan to make elections in these states should do so prior to the 2022 tax year-end to ensure PTET liabilities are fixed during the 2022 tax year. Election forms and methods can be found on each state’s website. Note that the Colorado DOR just weeks ago issued a new form DR 1705 allowing PTEs to make a 2022 accelerated election during the 2022 tax year. In New Jersey, PTEs are required to electronically elect prior to making any payments.
- California: In order to make the 2022 election, California required a minimum payment by June 15, 2022. This payment was required to be the greater of $1,000 or 50% of prior year PTET liability. If a PTE did not meet this requirement by June 15, it is prohibited from making a 2022 election.
- New York State and City: The 2022 New York State election was required to be made by September 15, 2022. Recently, New York City adopted a new PTET, first applicable to 2022. The New York City election can only be made if the New York State election is also made. Accordingly, if a PTE missed the September 15 deadline it cannot make the 2022 election.
- Oklahoma and Michigan: These states require elections by the 15th day of the third month of the election year (3/15/22 for calendar year PTEs), meaning these elections can no longer be made for 2022.
Other Major Year-End Considerations
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:
- Obtaining Owner Consent. Most PTETs require an election that is binding on all partners. Since PTET elections can impact different classes of owners in very different ways (majority v. minority; resident v. nonresident), there needs to be a process of obtaining consent among all owners. In some states such as California and Arizona, individual owners can opt out of an election made by the PTE.
- Possible Need for Restructuring. In some cases, a PTE will not be able to make an election based on its current ownership structure. In general, PTET elections cannot be made for disregarded LLCs. In many states, elections are prohibited for PTEs with owners who are also PTEs or corporations. In these cases, restructuring may be required before the PTE can qualify for an election.
- Resident Credit for Taxes Paid to Other States. Prior to making one or more PTET elections, it is important to review whether each owner will still be able to claim in his/her state of residence a credit for taxes paid to the other state. Some states may take the position that the credit cannot be claimed since the tax is paid at the entity rather than owner level. If this were the case, the owner could face double state taxation that far outweighs the federal tax benefit of an election. Some states have expressly denied the credit, and there is uncertainty in many other states.
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.