What Is Pass-through Tax Entity Elective Tax Status?

States are moving at an unprecedented speed to respond to the $10,000 federal cap on deducting state and local taxes. Many are offering what’s known as optional pass-through entity tax status as a workaround.  

For those who form eligible pass-through entities, this tax status allows individuals to deduct state taxes for federal tax purposes. It also provides credit or income exclusion for state income tax purposes. These matters can be confusing, so we’re here to explain how a pass-through entity works.  

Why Does the Pass-through Entity Tax Matter?

Most states didn’t impose a pass-through entity (PTE) income tax before the Tax Cuts and Jobs Act of 2017 (TCJA). However, the TCJA capped the deduction under IRC Section 164 for tax years beginning after 2017 and before 2026.  

The deduction is limited to $10,000 ($5,000 for married folks filing a separate return) for income or property taxes. Owning a PTE allows individuals to shift the payment of state income taxes to the entity and avoid double taxation.  

Qualifying for a Deduction

Notice 2020-75 states that partnerships and S corporations can deduct state income tax payments at the entity level. This excludes IRC Sections 702 or 1366, which determine the shareholder’s federal income tax liability of up to $10,000.  

The IRS and Treasury Department issue regulations based on state and local income taxes imposed on and paid by partnerships or S corporations.  

Some things should be kept in mind about how these elections work at the entity level, like whether some owners would benefit disproportionately from changing the preexisting agreement.  

For a pass-through business to qualify for this deduction, it has to be: 

1. A sole proprietorship
2. A partnership
3. An S corporation
4. A limited liability company (LLC)
5. A limited liability partnership (LLP)

The factors that distinguish these businesses are that they pay no taxes, and the profits or losses are passed through the company. As a result, the owners pay tax on the money on their returns at their tax rates. 

Establishing what’s critical for a pass-through can be a complicated task. In addition, certain aspects of these laws can vary from state to state, so it’s best to work with a professional who can help you navigate the laws that could affect how things work in your state right down to the letter. 

Are You Qualified to Elect PTE Tax?

There’s a lot to navigate when deciding on electing a PTE tax. The experienced tax attorneys at Hackstaff Snow Atkinson & Griess, LLC can help you decide whether forming a pass-through tax entity is advisable. Please schedule a consultation with our legal team today.