This article is intended for business owners who have Pass-Through Entity (PTE) profits (partnerships, multi-member LLCs, and S-Corporations). If this applies to you and you live or work in a state with state income taxes, please read on for additional information that has the potential to reduce your taxes.
What is the Pass-through entity tax?
As a result of the 2017 Tax Cuts and Jobs Act, joint tax filers are limited to a $10k Federal deduction on state and local taxes (SALT). Many states that impose income taxes recently introduced optional or required PTE level taxes as a response to this SALT limitation. Instead of passing business profits on to the taxpayer for payment at the individual level, the business entity may instead pay the state income tax liability. The states that have PTE taxes have given taxpayers a new option for who pays the state income tax liability.
Saving on taxes by paying the PTE tax
If the PTE pays the state income tax on its income, the income tax paid is a deductible business expense. States with PTE level taxes have two methods of recognizing the PTE’s tax payment – 1) provide a credit against state taxes for the tax paid by the PTE; or 2) an exclusion of the pass-through entity income for state tax purposes.
Let’s go through a simplified example. This is not intended to be, and should not be, taken as tax advice. The example does not factor in the potential loss of the Qualified Business Income tax deduction. Please consider the example below for a couple in New York who takes the standard deduction and has $100k in wages and $200k in PTE income. This example assumes the 2022 deduction and tax rates.
|Scenario 1||Scenario 2|
|PTE tax paid by individual||PTE tax paid by business|
|State Marginal Tax Bracket||6.85%||6.85%|
|State Tax Liability on PTE Profit||$13,700||$13,700|
|Federal Adjusted Gross Income (AGI)||$300,000||$286,300|
|Federal Taxable Income||$274,900||$261,200|
|Estimated Federal Tax Liability||$54,018||$50,730|
|Federal Tax Saving||$0||$3,288|
In Scenario 1, the business owner pays the state income tax on their tax return. In Scenario 2, the business pays the tax at the entity level. Notice that Scenario 2 has lower Adjusted Gross Income (AGI) because the business paid the state income tax and received a deduction. The couple was able to reduce their federal tax liability by $3,288 by having the PTE income tax liability paid by the PTE. At the state level, the individual received a credit that offsets the state income tax liability from the PTE profit. The federal tax liability decreased while the state income tax remained the same.
The rules for participation and the credits provided vary from state to state. In Connecticut, the PTE tax is mandatory. In Massachusetts, participation is optional, and the credit is only 90% of the state income tax paid by the business. Deadlines to elect participation also vary from state to state.
We recommend consulting with your accountant to determine if participation in your state level program would be beneficial in reducing your taxes. The higher your PTE income, the more opportunity there is to save.
As a reminder, Sensible Financial does not provide tax, legal or accounting advice. We recommend consulting with an accountant before making any tax-related decisions.