By: John S. Morlu II, CPA
In the world of business taxation, pass-through entities (PTEs) like S corporations and partnerships have traditionally faced unique challenges when it comes to deducting state income taxes. A key development, IRS Notice 2020-75, has significantly altered this landscape, offering PTEs a new tool to reduce their federal tax burdens. Here’s how this works and why it matters to small business owners.
The SALT Limitation Problem
Before IRS Notice 2020-75, state and local income taxes paid by owners of pass-through entities were treated as personal expenses. This created a two-step process:
- Owners reported their share of the business income on their personal tax returns.
- They paid state income taxes on their personal returns.
The problem worsened with the introduction of the State and Local Tax (SALT) deduction cap, introduced under the Tax Cuts and Jobs Act (TCJA) of 2017. This cap limited the deduction for SALT payments on an individual’s federal tax return to just $10,000. For business owners in high-tax states, this often meant that a large portion of their state income taxes wasn’t deductible, increasing their overall tax liability.
IRS Notice 2020-75: A Solution
IRS Notice 2020-75 provides a workaround for pass-through entities. Here’s what it allows:
- Deduction at the Entity Level: If a partnership or S corporation elects to pay state income taxes directly at the entity level, those taxes become deductible for federal tax purposes, just like they are for C corporations.
- Bypassing the SALT Cap: By making a PTE election, state income taxes paid by the business no longer flow through to the owner’s personal return, effectively sidestepping the $10,000 SALT cap.
This change aligns pass-through entities more closely with C corporations in how state taxes are treated, leveling the playing field for small businesses.
How PTE Elections Work
To take advantage of this opportunity, the business must meet certain conditions:
- State Participation: The state must allow PTE elections. As of early 2024, about 40 states have adopted some form of entity-level taxation for pass-through entities.
- State-Specific Rules: Each state has its own rules for making a PTE election, including deadlines, forms, and eligibility requirements. Business owners need to understand the specific laws in their state to ensure compliance.
It’s important to note that some states—like Texas and Florida—don’t impose a state income tax, so a PTE election is irrelevant in these cases.
Why Does This Matter?
The ability to deduct state income taxes at the entity level can lead to significant tax savings for business owners. Here’s why:
- Increased Deductions: By deducting state taxes at the business level, PTE owners can reduce their federal taxable income.
- Lower Effective Tax Rate: The deduction can reduce the overall tax liability, especially for businesses in high-tax states like California, New York, or Illinois.
Limitations and Considerations
While the PTE election offers clear benefits, there are some important caveats:
- State Variability: Not all states allow PTE elections. Even among the 40 states that do, rules vary widely.
- Temporary SALT Cap: The SALT deduction cap is scheduled to expire after 2025 unless Congress extends it. This could change the relevance of PTE elections in the future.
- Administrative Complexity: Making a PTE election requires additional paperwork and understanding of state-specific rules. Small businesses may need professional assistance to navigate the process.
What’s Next for PTEs?
With the SALT cap in place until at least 2025, PTE elections provide a valuable tool for business owners looking to optimize their tax situation. For many small businesses, this development narrows the gap between the tax advantages of C corporations and pass-through entities, making the latter even more appealing.
Final Thoughts
IRS Notice 2020-75 is a reminder of how the tax landscape is constantly evolving. For small business owners, staying informed about changes like PTE elections is essential for maximizing tax savings. If your state allows for a PTE election and your business qualifies, it may be time to take advantage of this opportunity. Consulting with a tax professional can help ensure you navigate the process smoothly and reap the full benefits of this game-changing rule.
Author: John S. Morlu II, CPA
John Morlu II, CPA, is the CEO and Chief Strategist of JS Morlu, a globally acclaimed public accounting and management consulting powerhouse. With his visionary leadership, JS Morlu has redefined industries, pioneering cutting-edge technologies across B2B, B2C, P2P, and B2G landscapes.
The firm’s groundbreaking innovations include:
• ReckSoft (www.ReckSoft.com): AI-driven reconciliation software revolutionizing financial accuracy and efficiency.
• FinovatePro (www.FinovatePro.com): Advanced cloud accounting solutions empowering businesses to thrive in the digital age.
• Fixaars (www.fixaars.com): A global handyman platform reshaping service delivery and setting new benchmarks in convenience and reliability.
Under his strategic vision, JS Morlu continues to set the gold standard for technological excellence, efficiency, and transformative solutions.
