CBA Record January-February 2022

Y O U N G L A W Y E R S J O U R N A L

corporate income tax, which changed from a progressive structure with a 35% top rate to a flat structure with a 21% rate. After TCJA, several states—especially high-tax ones such as California—enacted work- arounds to provide income tax relief for individual residents. In Notice 2020-75, the IRS rejected many state workarounds but approved the PTE. The IRS approved the PTE because the SALT Cap applies only to individuals, not entities. Without a PTE, members, partners, shareholders, and owners of pass- through entities generally pay state income taxes on their individual tax returns based on their share of the entity’s—that is, the partnership’s, LLC’s, or professional corpo- ration’s —state income tax liability. By con- trast, the PTE allows pass-through entity taxpayers such as partnerships, professional corporations, and Subchapter S corpora- tions to elect to pay state income taxes on the entity-level return rather than on the individual-level return of their members, owners, partners, or shareholders. Because no limitation applies for the amount of state taxes that a pass-through entity can deduct federally, imposing a state income tax directly on the pass-through entity effectively creates a federal deduction that then passes through to the entity’s mem- bers, owners, partners, or shareholders. Three Tax Considerations for PTEs Starting with the 2022 tax year and ending with the 2025 tax year, the Illinois PTE is available to any non-publicly traded partnership or Subchapter S corporation filing an Illinois income tax return. 35 ILCS 5/201(p)(1), (2). From an individual income tax perspective, the Illinois PTE potentially offers significant relief from the SALT Cap. Taxpayers should consider several issues—among others unique to

their circumstances—before making a PTE in Illinois or any state. First, taxpayers should consider a PTE’s administrative burden. Typically, a PTE is made on an annual basis or is irrevocable once made. In Illinois, a PTE is made on an annual basis but is irrevocable for each year once made. In other states such as Alabama, for example, where a PTE is irrevocable once made, an entity generally cannot revoke an election unless—after securing owner, member, partner, or shareholder consent—the entity submits a request to the state providing the reason(s) why a change in filing methodology is warranted and secures approval. Alabama Electing Pass-Through Entity Tax Act, H.B. 170, § 10(d) (Feb. 4, 2021). Second, taxpayers should consider how a state PTE will affect their individual income tax return. In some states, such as Illinois and California, individual owners of the pass-through entity making a PTE can claim an income tax credit for their share of the pass-through entity state income tax paid by the entity. For Illinois, the credit equals 4.95% times the partner or shareholder’s share of the entity’s net income. 35 ILCS 5/201(p)(4). In other states, individual owners of the pass- through entity making a PTE can reduce their state taxable income by the income included and taxed due to a PTE. Third, taxpayers should consider the consequences of making a PTE. For example, a state PTE tax rate may differ from the state’s highest individual income tax rate. Although the Illinois PTE tax rate (4.95%) is currently the same as the state’s flat individual income tax rate, the California PTE tax rate is currently 9.3%, whereas that state’s highest individual tax rate is 12.3%. Of course, taxpayers should also con- sider pending and potential federal income tax legislation. For example, the proposal in the U.S. House of Representatives’ version of the Build Back Better Act is to raise the SALT Cap from $10,000 to $80,000 and to sunset that amount through 2030, with the cap reverting to $10,000 in 2031. The U.S. Senate may adopt further changes, such as imposing

an income threshold of $400,000, which would limit PTE benefits for law firm partners, shareholders, or owners making above $400,000 in taxable income. As of this article’s publication, however, these provisions appear to be subject to further negotiation. Currently, 21 states have some form of PTE to offer SALT Cap relief to individual residents (Alabama, Arizona, Arkansas, California, Colorado, Connecticut, Geor- gia, Idaho, Illinois, Louisiana, Maryland, Massachusetts, Minnesota, New Jersey, New York, North Carolina, Oklahoma, Oregon, Rhode Island, South Carolina, and Wisconsin).

Nick Aylmer, CPA, is a senior associate at BKD, LLP, where he provides tax compli- ance and provision services to clients in multiple industries, including manufac- Ted Kontopoulos is a Co-Editor in Chief of the YLS Journal in the CBA Record, a Chair on the YLS Business LawTransac- tions Committee, and a senior international

turing and distribution.

tax consultant at BKD, LLP, where he pro- vides tax controversy, compliance, and plan- ning services to businesses, individuals, trusts, estates, and not-for-profit organizations.

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