Let's take a trip down memory lane. The year is 2017, President Trump is in office, and the Tax Cuts and Jobs Act (TCJA) is signed into law. Among a myriad of other tax law changes, the TCJA limits the deduction individuals may take for state and local taxes to $10,000 on their individual income tax returns (i.e., the SALT Cap). The limitation sunsets, like many of the provisions within TCJA, at the end of 2025.

States reacted by developing a workaround to the SALT Cap in the form of a pass-through entity tax (PTET). Flow-through entities (partnerships and S corporations) are not subject to the federal state tax deduction limitation. The PTET lowers the distributive income to the partners or shareholders, effectively providing a full federal deduction for state taxes paid. Connecticut led the charge, developing this now common taxing regime by first enacting a mandatory PTET, which it later changed to an elective PTET, starting in 2024. Other states followed by enacting their own elective PTET regimes. While the elections are made and taxes are paid at the state level, the partners/shareholders receive the tax benefit at the federal level.

Current Status

Nearly every state with a personal income tax on flow-through income has enacted a PTET (36 states and one locality, with Maine, Pennsylvania, and Vermont having each proposed legislation), leaving only three states with a personal income tax that have not enacted or proposed a PTET.

The PTET election, in the states where it is available, allows a flow-through entity to pay tax on income sourced to the state and the owners to receive a credit or income exclusion. While this should result in a benefit to the individual owners, several issues should be reviewed before making a PTET election:

• Differing tax bases for residents and non-residents,
• Varying eligibility rules depending upon the composition of the owners,
• Differing election due dates, forms, and payment dates,
• Haircut on credit received by the partners/shareholders,
• Tax rate used,
• Impact on other state tax credits,
• Credit or income exclusion, and
• Refundability of credit.

What's Next?

The SALT Cap is set to expire for tax years beginning on or after January 1, 2026. Not all states tied their PTET to the SALT Cap. Unless changed, certain PTET elections may survive the sunset of the SALT Cap. On the flip side, if Congress extends the SALT Cap, certain state PTETs may nevertheless expire as a result of the state adopting a specific date range for the PTET to be effective (rather than tying their PTET to limitations under Sec. 164(b)(6) of the Internal Revenue Code). These states would need to extend the PTET to retain the SALT Cap workaround:

• Illinois law provides that the PTET will be effective "for taxable years ending on or after December 31, 2021, and beginning prior to January 1, 2026," yet also ties it to the taxable years that the limitations under Sec. 164(b)(6) apply. This conflicting guidance could lead to confusion if the SALT Cap is extended.
• California law states that the PTET will be effective "for taxable years beginning on or after January 1, 2021, and before January 1, 2026." California's PTET will expire absent an extension, aligned with the current SALT Cap sunset.

In contrast to Illinois and California, New York law is silent on the expiration of its PTET. Absent enacting new legislation, New York's PTET regime will continue for years following the sunset of the SALT Cap.

Not only should partners/shareholders track each state's PTET sunset provisions, but they should also eye potential federal changes. Since the SALT Cap was adopted, a constituency primarily comprised of Congressional lawmakers from high-tax states have sought to repeal or increase the limitation (e.g., to $100,000 for individuals and $200,000 for married couples filing jointly) without success.

Over the coming years, partners/shareholders should follow legislative developments at both the federal and state levels. The PTET has been an evolving area over the past few years, with early adopters modifying existing regimes and several new states enacting new ones. While the statutory language is similar in many states, there can be surprises. For example, in its adoption of a PTET effective starting in 2023, Montana allows a pass-through entity with resident owners to make an election even if the pass-through entity has no business activity in the state.

The Takeaway

The PTET can be a beneficial election for owners of flow-through entities because it allows partners and S corporation shareholders to avoid the federal SALT Cap. However, there can be pitfalls, as discussed above, if not analyzed properly, both in the states where elections may be made and in those where it is not made. A careful review of each situation is required before electing any state's PTET. Contact a member of Andersen's State and Local Tax Team to find out how a PTET election may impact your business.