Reduce Your Federal Tax Bill
Many real estate business owners may be able to reduce their federal tax bill by taking advantage of state-level elective pass-through entity taxes, which have proliferated over the last five years. These businesses will often operate as a partnership, LLC, or S corporation, and the owners may find themselves with significant savings opportunities if the business structure and footprint are just right.
Background.
Back in 2017, as part of the Tax Cuts and Jobs Act, Congress capped the individual itemized deduction for state and local taxes at $10,000. Also known as the “SALT Cap.” (Time will tell whether Congress will let the SALT Cap expire, extend it, raise it, or something else.) The IRS blessed a partial workaround to the SALT Cap in IRS Notice 2020-75. This Notice states taxes paid by a partnership or S corporation to satisfy a state or local income tax imposed on the partnership or S corporation are deductible to the partnership or S corporation and not subject to the SALT Cap – at the entity and owner levels. The SALT Cap is set to expire after 2025 and will undoubtedly be a hot topic on Capitol Hill this year.
State Elections.
Over the last few years, almost every state with an individual income tax, including Ohio, has enacted an elective pass-through entity tax (“PTET”). A PTET allows a pass-through entity to pay tax on its income directly, rather than passing it through to be taxed at the owner level. Every state’s PTET is a little different, but here is a simple illustration of how a typical election might help owners save taxes:
Suppose LLC owns and operates several apartment complexes located in State A. LLC has two individual members who reside in State A and share LLC’s profits 50/50. State A’s income tax rate is a flat 4% but State A also has a PTET. LLC has a profit of $2,000,000.
- If LLC does not make the election, then each member will pay $40,000 of State A income tax ($1,000,000 x 4%) and will be limited to a $10,000 deduction on the member’s federal tax return.
- Alternatively, if LLC makes the election, LLC will pay $80,000 of State A tax. Those taxes are fully deductible to LLC on its federal return and to each member. Each member will effectively get a $40,000 deduction rather than $10,000. At the top marginal tax rate of 37%, each member will save $11,100 in federal taxes ($30,000 x 37%). State A requires each member to reverse the $40,000 tax deduction but allows a credit for those taxes, resulting in a net neutral tax effect for State A income tax.
Does An Election Work For My Business?
In a simple scenario like the one above, the benefits of a PTET are straightforward. However, many situations are not so simple and every state’s PTET has its nuances. Not surprisingly, this can get complex in a hurry.
States have generally tried to provide a PTET that achieves the federal benefit without imposing a state tax cost or heavy compliance burden. Nevertheless, there are many things to consider before making an election in any state, including:
- What type of entities and owners are eligible
- When the election must be made
- Who must approve the election
- How the tax base is calculated
- Cash flow (e.g., estimated payment requirements, whether the state credit is refundable to the owners)
- Costs of compliance (e.g., additional tax returns, accounting fees, possible legal fees)
For a business with properties or owners in multiple states, it is especially important to review each state’s PTET to understand the federal benefits and state requirements. Every state has unique procedures and forms, and the rules for an owner claiming credit for taxes paid to another state vary as well.
It bears repeating that each state’s PTET is a little different. If a business has the right facts and otherwise qualifies to make the election, the federal tax savings can be significant. Careful, thoughtful, and timely analysis is key to planning for these savings.
If you’d like to learn more, contact the real estate and state and local tax professionals at GBQ today.
By John Petzinger, state and local tax services