Seasoned Conversations with SALT - Episode 6
Partner Jeff Burns continues the Seasoned Conversations with SALT video series with partner Nick Palmos and director Brad Wilhelmson.
In this next episode of Seasoned Conversations with SALT, Partner Jeff Burns has a discussion with Partner Nick Palmos and Director Brad Wilhelmson on a number of new state elective passthrough entity taxes (PTET). Various PTET regimes have come about since the IRS released Notice 2020-75 in November 2020 in an effort to combat the $10,000 cap on deducting taxes at the individual level for federal income tax purposes. In the episode they cover some of the complexities and different ways to address the multistate issues.
JB: All right, so welcome back to another episode of Seasoned Conversations with SALT. This time, this is going to be a continuation of a previous discussion that we had on PTET. You know, we talked about New York and the implications there, but now I want to talk a step back and have a much broader discussion on PTET. So, with me today is Nick Palmos, a partner out of our Dallas office and Brad Wilhelmson, a director of our Washington National Tax State and Local Group. So, gentlemen, welcome today to the conversation. I appreciate you being here. Let’s start off, Brad, I’m going to start with you. Could you give us a bit of the basics, if you will, on PTET and some background as to what we actually mean when we talk about PTET.
BW: Sure. Thanks, Jeff. So, pass-through entity taxes aren’t themselves new. A number of states have had pass-through entity taxes for some time. States also have other obligations that apply to pass-through entities, like non-resident withholding, composite returns. States are trying to collect the money related to the tax that may be owed by the owners of these entities and they can more directly collect that directly from the pass-through entity.
But what we’re here to talk about today is the elective pass-through entity taxes that have arisen since the Tax Cuts and Jobs Act and it’s $10,000 limitation on itemized deductions for individual taxes. And why this topic is particularly timely is the number of new elective pass-through entity taxes that we have since the IRS released notice 2020-75 last November.
These plans, these pass-through entity tax plans have been in discussion since the Tax Cuts and Jobs Act came out, a number of professionals, and professors and other professionals in the tax community were thinking about what’s the type of obligation, what type of expense would not be subject to these $10,000 limitations. A number of states enact charitable deduction plans where you would make a charitable deduction to an entity and then the state, under its law, would then give you a credit, making you net whole. The IRS spoke to those types of plans and said, this is a quid pro quo relationship, you’re getting something back for your deduction of a contribution and so we’re not going to view it as contribution. You’re still going to be subjected to the $10,000 limitation.
These pass-through plans, it’s a much smaller audience that can take advantage of these plans. You have to be an owner in a pass-through entity and the IRS last November in the Treasury in the IRS, and last November, issued notice 2020-75 which said that ... showed an awareness of what was happening in the market, that these plans were elective, pass-through entities were allowed to elect into these plans and that owners were given a credit or an income backout as related to their pass-through entity electing into one of these plans. And it’s said in the notice that if this is an obligation of the pass-through entity, then that is an expense of the pass-through entity that is not subjected to this $10,000 limitation. That’s an amount deducted by the partnership, flowing through to the owners and then isn’t subjected to $10,000 limitation as a partnership, not an individual expense.
Spurred by that notice, we’ve seen a number of states now issue elective pass-through entity plans that are available for pass-through entity that are doing business in those states. We’re actually up to ... if you take out the states without a personal income tax, now we’re up over to half of the states that have enacted these types of plans. Some of them start in 2021, some of them start in 2022, some of them were from even years prior to this back to the Tax Cuts and Jobs Act.
Generally, these have been elective plans. Connecticut was the first and they were a mandatory plan with an elective alternative base, but since then, these plans are elective, so it’s really up to the pass-through entity, its owners, to decide if they want to make it as election, pay tax at the entity level, thereby making it easy for the state because they’re getting the money directly from the pass-through entity and the owners are getting a credit or an income backout, so they’re being made whole, but then getting a federal deduction for those expenses for the pass-through entity tax.
JB: Interesting. So, here we are, you talked about TCJA. Four years later, we’ve got these elective PTETs coming through. Brad, that background is extremely helpful. Nick, I’ll come to you with this next question; so just given what Brad’s just said, it sounds very complex, where are we seeing this play out and what are some of the benefits in that area?
NP: Yes, sure, Jeff. So, if you think about (Inaudible), the purpose here, right, is to combat against the SALT cap from a personal income tax perspective, right? So, where would your individuals be invested in partnerships? First you can think of really just maybe an operating partnership if there are service partners within that partnership. I have some clients where ... and you can think of law firms, accounting firms for one, I know that our firm is looking into the deduction for our partners’ purposes, as well ... but just any type of operating partnership that’s usually service-based partnership that has individuals performing services, right?Multistate operation or maybe even just a few states where there is a state income tax burden, those individuals would be subject to income tax, multistate taxation and potentially they’re over the cap in those situations.
The other place that we’ve been seeing this is in your private equity structures, generally toward the top of those structures where you start to have more individuals invested into the partnership. It might be the employees, or the principals of the business invested directly at the top of the structure. Potentially in the family office space, as well, right? Aggregation of investments of multistate businesses running through a partnership structure and ultimately getting allocated. Again, you’re looking at mainly individual-type taxpayers coming in through the partnerships because those are the individuals that are subject to the SALT cap.
Again, as Brad explained, the purpose of these elective regimes isn’t really to reduce your state tax burden, it’s to reduce your federal tax burden through the virtue of the state tax expense. What you’re really doing is in a typical flowthrough structure, the income is going to flow through the partnerships, out to the individuals and subject those individuals to state income tax at the personal level. When those personal income taxes are incurred, again, they’re going to get aggregated to then be subject to the $10,000 limitation.
Well, if the partnerships themselves can elect these regimes, pay the same amount of tax, in some instances there might be a small state tax increase just due to the nature of the regime and the amount of credit that flows through the individual, but there is going to be a benefit gained, a federal benefit tax effect(?) of that expense that’s now moving within the partnership. So, now that partnership, that tax expense is no longer subject to that SALT cap, and they get a full deduction of the state tax that’s incurred. So, you’re basically moving the expense down a level inside the business and those taxes and deductions are no longer subject to the cap.
JB: Just a quick follow up question to that, Nick, as you explained it. So, the elections made at the partnership level, does there have to be ... if there are multiple partners in that partnership, does there have to be collective agreement amongst the partners?
NP: As with everything, I’m sure you’ve asked questions and always get the answers, that depends, right? So, as Brad stated, we’re up to so many states enacting these regimes and no state has enacted a regime precisely the same. That’s also one of the complexities that go along with these, and we can talk about those for a minute, it’s just the compliance burden involved in this analysis. Some states require all partners be included in the election. It’s an all-or-nothing analysis. Some states have gone to more of an elective regime partner by partner. Those elective regimes sometimes border, beg the question, is this truly an entity-level tax or is it more of a composite tax to where it might not be subject to the deduction?
Then lastly, some regimes just statutorily allow certain types of partners and certain types of partners to not be allowed into. So, some regimes don’t allow entity type partners in the election and only allow individuals and trusts. Some regimes allow entity types in the tax base such as partnership partners and the credit tiers up against the mandatory regime that we were talking about in Connecticut.
JB: Perfect. Thanks, Nick. Brad, Nick talked about where this applies. What are some situations where this may not apply?
BW: Yes, it’s definitely not a one-size-fits-all answer. I mean, first we’re starting with the limitation that it’s flow throughs and flow through owners, so you have to be an owner or maybe a form of flow through entity to be able to take advantage of these plans.
Second, you have to be generally in states that have this type of a plan and some of the effective dates there, some are previously effective, some are 2021. A lot of the new ones are even 2021 because the small business push at the state level to get these bills on the books, to get this deduction wanted it sooner than later, so number states are ... even the new states are 2021 states, which is making things somewhat difficult from departments. Revenue usually has a little more time to release guidance on how a new tax or a new (Inaudible) requirement would work and there being pressed on time given the timing of when these were enacted and when they’re effective and then some will be effective just 2022 and going forward.
So, we tend to find that there is sort of gating questions in working with our clients that we’re seeing. Once we answer those, it will give at least a quick sense of is this potentially a good fit for you, is this going to provide an overall benefit or is it not? Once we get through that initial phase of saying, well, it looks like there may be a benefit here, then we get into a little more detail looking at things like does an individual owner get credit for taxes paid representation for the pass-through entity taxes that this pass-through entity is paying to other states. Because if not, there can actually be an overall detriment to the plan given that while you may get additional federal benefit, you may be losing a state tax credit that was offsetting your state tax liability on more of a dollar-for-dollar basis.
JB: Interesting. So, you touched a little bit on it, Nick. Brad, you just mentioned it there, but Nick, what really are the federal implications of this as we think about it? Because it’s a state rule, it’s an election. What happens at the federal level?
NP: Yes. Again, to build on the state analysis that has to happen and some of the compliance topics that I talked about earlier, there are other federal implications to think about, as well. In addition, you know, we’ve been talking about the whole SALT cap, right? So, there’s that modeling exercise to determine is there benefit to be gained, right? But even with the passage of notice 2022-75, there is still a question as to whether or not your partnership structure, if you’re in a tiered partnership structure and maybe it’s investment through a family office-type vehicle, that your partnership structures aren’t in ordinary trader business(?).
The notice specifically speaks to this and we’re comfortable that the deduction would be allowed there, but there might be some partnerships that this deduction, albeit it would be a deduction within the entity, still would not, still would be a different itemized deduction and therefore not get the SALT benefit here. So, there is analysis from that federal perspective.
We talked about different partners being able to elect in, different partner types not being allowed into the election. Well, now you have an expense that’s going to be specially allocated among your partners that means to likely follow this credit that’s going to be allocated to the partners. So, there’s the federal implications of special allocations that you need to address and are these special allocations going to have substantial economic effect.
Other things, too, is to think about from a modeling standpoint is your certain partners that aren’t partners now, maybe there are employees that get paid and they’re in their home state. Well, there might be some employee compensation arrangements that can be determined from a business perspective and looked at to say, well, you know, maybe we can benefit our partner class or our employee class by making them partners and affecting, helping them out from a tax perspective.
So, all types of different things to think about in terms of the business aspect of this, as well, in addition to simply the SALT benefit gain.
JB: So, it sounds like, A, this is very complex, B, the best place is to really start with the modeling and then with that’s going to come the compliance and reporting aspects of it. So, I guess final question for both of you, and Brad, I’ll start with you and then Nick, to you. Brad, if there is one thing you can leave everybody with after this today, what is it?
BW: I think it goes back to something that we’ve been kind of talking through, it’s that it’s not a one-size-fits-all plan, that there are really a lot of state-specific nuance to address and that it can provide a significant advantage, but it’s important to firm up if that advantage is going to actually apply to your structure and your owners.
JB: Perfect. Nick, what’s the one thing from your perspective?
NP: Yes, I would say, if you hear about this in the news or from this podcast, give us a call. We’re happy to have a conversation around this. I want to really help provide a benefit through an avenue that’s really been blessed by the IRS and the states are on board with this, as well, so it’s really a good answer in terms of helping our clients out on this. I would say just pick up the phone and give us a call.
JB: Perfect. Well, thank you both for jumping on this episode, talking through a very complex issue. I think you’ve simplified it as best you can and talked about the different ways that companies should be looking at this. So, thank you very much and we look forward to catching up soon.
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