Tax benefits of paying pass-through entity tax
by Bruce E. Bell, CPA/Attorney
Bruce E. Bell is a CPA/Attorney practicing at the Chicago law firm of Schoenberg Finkel Beederman Bell Glazer LLC. A founding member of the firm, Bruce chairs the firm’s transactional and tax practices. He concentrates on federal tax, estate planning and general business matters. Bruce can be reached at 312-648-2300 or firstname.lastname@example.org.
In the last several years, many states have enacted legislation imposing a passthrough entity tax. The tax is designed to help business owners pay a tax-deductible state income tax at the entity level to avoid limitations on deducting state income taxes on their personal federal income tax returns. For those entities which are eligible, the entity tax can provide a meaningful benefit for business owners.
Pass-through entities are, generally speaking, those organizations that are not subject to federal income tax at the entity level. Rather, income is reported by the owners on their personal income tax returns who are taxed on their respective shares of company income. The most common types of pass-through entities are limited liability companies owned by more than one person, partnerships and S corporations. Passthrough entities do not include regular or C corporations as these entities are subject to income taxes at the corporate level.
To understand the benefits of the new pass-through tax, a review of two key provisions of the last major piece of federal tax legislation is necessary. The 2017 Federal Tax Cuts and Jobs Act imposed a $10,000 limit on the amount of state and local income tax that taxpayers can deduct for federal income tax purposes. Prior to this legislation, taxpayers could claim as itemized deductions on their personal income tax returns real estate taxes, state income taxes and certain other state and local taxes paid. Coupled with another change in the 2017 Tax Act, the increase in the threshold for claiming itemized deductions, many taxpayers are now either limited in the amount of state and local taxes they can deduct and/or prevented from claiming any itemized deductions on their personal income tax returns. The laws which have been enacted by many states are designed to afford taxpayers the benefit of the state and local tax deductions they lost under the 2017 Tax Act, regardless of whether they itemize deductions on their personal income tax returns.
While the rules vary from state to state, under a common statutory scheme, income tax can be paid by a pass-through entity if the entity so elects. When the entity pays the state income tax, the business owners receive corresponding credits on their personal income tax returns for their share of the tax paid by the entity. Essentially, the pass-through entity is paying the tax on behalf of the entity owners. The amount of the tax the owners pay to the state will not change. The benefit to the owners is that the pass-through entity tax the owners pay will reduce the owners’ share of the income the owners report for federal income tax purposes. The owners are then left in the same position as if the owners were able to claim as itemized deductions the state tax payments.
Assume Glen is the sole owner of his S corporation and reports income from the corporation of $300,000 per year, apart from his salary. Also assume Glen is subject to income tax of $15,000 on this income and he will not be able to fully deduct this amount on his personal income tax return. This is due to the 2017 Tax Act which limits the amount of Glen’s state tax itemized deduction to $10,000. Moreover, unless Glen has other deductions which cause his itemized deductions to exceed the increased threshold, he will receive no tax deduction for the $15,000 state tax payment.
Now assume that Glen’s S corporation elects to pay the $15,000 pass-through entity tax. In this case, Glen will only report income from his S corporation of $285,000, the difference between his $300,000 of total pass-through income and the $15,000 of tax paid by Glen’s S corporation. Glen will receive a $15,000 credit against his personal state income tax obligation. By reporting only $285,000 of pass-through income, Glen is in the same position he would have been in before the 2017 Tax Act where he would report $300,000 of pass-through income and be able to deduct his $15,000 state tax payment as an itemized deduction.
The imposition of these new state entity taxes should cause business owners to reevaluate their organizational structure. With S corporations and multi-member LLCs being the primary beneficiaries of the pass-through entity tax, many business owners may opt to convert their entities to become pass-through entities eligible for the pass-through entity tax. In some states, the pass-through entity tax will not apply to single-member LLCs so a single-member LLC may consider adding a member or owner to become a multi-member entity that qualifies for the tax and the accompanying credit. Alternatively, single-member LLCs may elect to become S corporations thereby qualifying for the new pass-through entity tax. Regular corporations may elect to become S corporations for the same reason.
As counterintuitive as it may seem, eligible entity owners will actually enjoy an overall tax benefit by having their passthrough entities pay a tax they are not otherwise obligated to pay. Unless Congress chooses to rescind the limitations on state and local income tax deductions and reduce the threshold for claiming itemized deductions, small business owners which reside in states which have enacted pass-through entity taxes should take advantage of this new opportunity.