In 2017 the passage of the Tax Cuts and Jobs Act (TCJA) changed how many businesses pay taxes. The most significant change was lowering the corporate tax rate to a flat 21% versus the previously tiered rate ranging from 15% – 39%. But another monumental alteration to the tax code was the addition of a $10,000 cap for deducting state and local taxes (SALT).
As a result, many business owners found themselves responsible for significantly higher tax liabilities because they could not deduct as much as before the passage of the TCJA. In response, some states created a workaround with pass-through entity taxes (PTET).
What are pass-through entity taxes (PTET)?
C corporations are subject to “double taxation,” meaning they pay both corporate taxes and dividend taxes. However, most small businesses in the US are pass-through entities (also known as flow-through entities). In other words, the company does not pay corporate taxes but passes the responsibility on to business owners, shareholders, and partners.
While varying from state to state, the tax workaround generally allows business filing as a pass-through entity to bypass the $10,000 deduction cap for the states that have adopted it as law. The new law enables business owners and vested parties to pay taxes only at the federal level.
Initially, it was unclear what the IRS’s position would be on the workaround. Then, in November of 2020, it issued Notice 2020-75, which essentially gave approval for the loophole. More states passed PTET legislation, and others are currently in the process of doing so.
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Examples of pass-through entities
C corporations cannot be pass-through entities, but most other business types are eligible to file as pass-through entities. These include:
- Sole proprietorships
- Partnerships
- LLCs
- S corporations
Benefits of pass-through entities
One significant benefit of the PTET workaround is that it allows businesses to lower their tax liabilities by surpassing the $10,000 deduction cap. It also avoids the double taxation that C corporations face. PTET filers don’t pay the Alternative Minimum Tax (AMT), which is sometimes applied to higher-income brackets (depending on the state). Also, eligible businesses receive a tax credit for taxes paid in other states.
Other factors to consider
Each business’s tax situation is unique. As a result, there’s no guarantee that PTET will automatically lower tax liabilities. Not to mention, each state’s laws vary on the subject, and not all states have approved it.
Other factors to consider include:
- Reasonable compensation: Businesses need to pay their shareholder-employees what the IRS considers a “reasonable salary” to deduct them. Some companies have tried to keep wages low for shareholder-employees to keep Social Security and Medicare taxes minimal. However, the IRS disapproves of this tactic, which may expose your business to an audit.
- Losses: If your business consistently files at a loss, it makes sense to file as a PTE because C corps can’t deduct losses from their owners.
- Assets: Real estate and other assets that may appreciate may be taxed if sold by the business.
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Finalizing the PTET decision
The TCJA has created long-lasting ramifications for business owners and added layers of consideration to the many decisions they must make annually. Confounding the decision-making process are laws varying from state to state about PTET. Therefore, business owners must consult with experts before deciding on business organization changes.
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