Pass Through Entity Tax: A New(ish) Deduction

Are you a California business owner that hates paying taxes? Pass Through Entity Tax (PTET), may provide a workaround for you. Prior to 2018, individuals were able to deduct all state income tax and property tax when filing their Federal tax returns. These deductions are often referred to as a SALT deduction for short. After the passage of the tax cuts and jobs act (TCJA), SALT deductions were limited to $10,000. This cap hit high-income taxpayers in high-tax states like California hard. In 2023, a California couple earning $500,000 would be in the 9.3% state tax bracket and would owe $40,007 in state income taxes. Where this amount was previously fully deductible on their Federal tax return, it is now capped at $10,000, leaving $30,007 of non-deductible expense on the table.

What is the Pass Through Entity Tax strategy?

Pass Through Entity Tax (PTET) fixes this problem by allowing business owners to shift their tax payments from being a personal expense to a business expense, which circumvents the SALT deduction cap. Furthermore, business owners can also receive a state tax credit against their individual tax liability to partially or completely equate to the tax paid by the business (state dependent). To be eligible for this tax strategy your state must allow businesses to make a PTET election. 33 states, including California with the passage of AB150, have made this possible for business owners.

Additional Tax Benefits of PTET

In addition to being able to avoid the SALT cap of $10,000, there are some potential ancillary benefits to PTET. First, a PTET election can lower your adjusted gross income (AGI) by virtue of the business passing less income through to you. A lower AGI can reduce Medicare premiums, reduce net investment income tax (NIIT), increase Roth IRA contribution eligibility, and can reduce limitations on deductible losses from rental real estate. Reduced taxable business income can also result in lower self-employment taxes, and create a double dip scenario where a business owner may become eligible for preferential tax rates through qualified business income (QBI).

The Downside of PTET

For all of the benefits of a PTET election, there are some potential issues. In California, and other states, an individual could ultimately end up paying higher state income taxes, which is caused by the interplay between business income being taxed at a flat rate v. individual income being taxed on a graded scale. Depending on how your state allows for PTET, you may not receive a full tax credit against individual state taxes, which would effectively result in double taxation. This is not the case in California, but other high-tax states have different rules. Business owners doing business in multiple states face additional layers of complexity, including claiming residency in one state over another. Expect a lot more interaction with your tax preparer if you go down this route.

Who is a good candidate for this tax strategy?

An ideal candidate is someone who is a high-earner, owner of one or more pass through businesses (partnerships, LLC’s and S-Corps), and lives in a high-tax state. For those who are not ideal candidates, there are still several exceptions where things may work out favorably. If you have a business, we encourage you to speak with your advisors and tax professionals to evaluate this strategy in the context of your financial plan.

The information provided herein is for educational purposes only, and should not be construed as advice, including, but not limited to tax, legal, insurance, investment, or retirement advice. For your specific planning needs, please seek the advice of Integris Wealth Management, your tax accountant, attorney, insurance agent, or other professional as appropriate. Investing involves the risk of loss.