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Passthrough Entity Taxes — Southeast Focus

Posted on Oct. 4, 2021

Veronica Caputo is a state and local tax partner in Grant Thornton LLP’s Atlanta office, and Jason Wade is a SALT director in the firm’s Atlanta office.

In this installment of Taking SALT for Granted, Caputo and Wade summarize and compare the elective passthrough entity tax laws enacted in Alabama, Georgia, Louisiana, and South Carolina.

This article summarizes and compares the elective passthrough entity (PTE) tax laws enacted in four states in the southeastern United States: Alabama, Georgia, Louisiana, and South Carolina.1 After separately discussing the PTE taxes for these states, the article addresses some of the key factors that should be considered in determining whether to make a PTE tax election. These PTE taxes have received considerable attention and are the states’ response to the $10,000 limit on state and local tax deductions allowed for individual federal income tax purposes that was part of the Tax Cuts and Jobs Act and remains effective through 2025.2

Historically, partnerships generally have not been taxed at the entity level for federal and state income tax purposes. Instead, the partners would include their distributive share of partnership income or loss, whether distributed or not, on their tax returns in the year that the income is earned.3 Likewise for S corporations, such an entity is not taxed at the entity level and its shareholders pay income tax on their share of the S corporation’s income or loss.4 The partners and shareholders in turn pay nonresident state income tax on their apportioned distributive share of income. The income tax paid by the PTE owner would count toward the $10,000 deductible state tax expense for federal income tax purposes.

By electing to treat these PTEs as taxable entities for state income tax purposes, the income tax paid is an entity-level tax and does not count toward the owner’s state tax deduction cap for federal purposes. The IRS has said that this PTE tax election is a viable option to allow owners to be able to deduct state taxes paid over the $10,000 cap.5

Multiple states have recently enacted PTE tax regimes, with many doing so after IRS approval of the entity-level workaround.6 The mechanics of these taxes are inconsistent, leading to many questions. How will the states view nonresident owners from a nexus perspective post-election? Will other states allow for a credit against their income tax for taxes paid by the entity in an electing state? How will the election affect the accounting for income taxes of publicly traded companies? The answers may turn in part on how the states choose to implement these PTE tax elections. Before addressing these questions, this article first provides a summary of the PTE tax laws enacted by four southeastern states.

I. Alabama

For tax years beginning on or after January 1, 2021, S corporations and partnerships may elect to be taxed at the entity level in Alabama as an electing PTE.7 The PTE will be subject to the highest marginal individual income tax rate, which is 5 percent.8 The tax is based on apportioned Alabama taxable income as defined under existing rules, and the Alabama entity-level tax is not deductible to the PTE.9 The PTE is required to make estimated payments in accordance with the rules for corporations.10 As enacted, upon making this election, the entity’s partners, members, and shareholders were not liable for taxes on their pro rata or distributive share of the PTE’s income that would otherwise be imposed by Alabama.11 However, legislation enacted in May converted the exclusion from income to a credit for the owners of the electing PTE in an amount equal to their Alabama share of income tax paid by the PTE.12

Qualifying entities must elect to be taxed as a PTE on or before the 15th day of the third month following the close of the tax year for which the entity so elects. The election is binding for that tax year and all tax years until the election is revoked by the PTE. Similarly, a revocation must be submitted on or before the 15th day of the third month following the close of the tax year in which the entity no longer wants to be taxed as a PTE. Both the election and revocation must be accompanied by a vote or written consent of the governing body’s members, and a vote or written consent of the owners, members, partners, or shareholders holding greater than 50 percent of the voting control of the entity.13

The Alabama Department of Revenue has issued a proposed regulation regarding electing PTE returns.14 It provides among other things that owners of an electing PTE would be required to file an Alabama return to report their pro rata or distributive share of the income of the entity.15 This income may then be offset by the credit mentioned above that is available to the owner in an amount equal to its pro rata or distributive share of the Alabama income tax paid by the electing PTE.16 This proposed regulation requires that the election be made on form PTE-E, “Pass-Through Entity Election Form.”17

II. Georgia

With the enactment of H.B. 149 on May 4, Georgia created an optional PTE tax for flow-through entities.18 For tax years beginning on or after January 1, 2022, S corporations and partnerships may make an annual irrevocable election to be taxed at the entity level on or before the due date of the return, including extensions.19 The electing entity will pay a 5.75 percent tax on its Georgia taxable income, less any deduction for income and gross receipts taxes.20 The legislation provides that resident partners and shareholders of electing entities are not permitted a credit for taxes paid under the new PTE tax.21 Instead, the income that is taxed under the PTE tax is excluded from the calculation of Georgia taxable net income for the individual owners.22 The PTE makes the election and the consent of the owners is not required.

III. Louisiana

On June 22, 2019, Louisiana became the first southeastern state to enact a PTE tax.23 Effective for tax years beginning on or after January 1, 2019, an S corporation or any entity taxed as a partnership may elect to be taxed at the entity level as a C corporation.24 The election is not available to entities filing a composite partnership return.25 The election must be made in writing on Form R-6980, “Pass-Through Entity Tax Election,” and can be made during the preceding tax year, or at any time during the tax year up to the 15th day of the fourth month after the close of the tax year.26 The election requires the consent of shareholders, partners, and members owning more than 50 percent of the entity. Once made, the election is effective for the year for which it was made and for all succeeding tax years, until the election is terminated.27 An entity may apply for termination if its shareholders, partners, and members owning more than 50 percent of the entity consent.28

The tax is applied on a graduated scale, with the first $25,000 of taxable income taxed at 2 percent, taxable income from $25,001 to $100,000 taxed at 4 percent, and taxable income of greater than $100,000 taxed at 6 percent.29 Further, an entity that has made this election is allowed a deduction in an amount equal to the federal income tax the entity would have paid on its Louisiana net income for the tax year if it had been required to file a federal income tax return as a C corporation.30

Owners of entities making this election may exclude the related net income or loss from the entity from their Louisiana individual income tax returns, provided the entity properly filed a Louisiana corporate income tax return.31

IV. South Carolina

For tax years beginning on or after January 1, 2021, South Carolina has an annual elective PTE tax for qualified entities.32 These are defined as partnerships, S corporations, or limited liability companies treated as partnerships, if all owners are qualified owners or partnerships that are owned directly or through other partnerships by qualified owners.33 Qualified owners are defined as partners or shareholders of a qualified entity that are individuals, estates, trusts, or any other entity except those taxed as corporations, small business trusts, or exempt organizations.34

The PTE tax election may be made annually but is due on or before the applicable income tax return filing due date, including extensions — namely the 15th day of the third month after the end of the tax year for partnerships and S corporations, with a six-month automatic extension when filing a federal extension.35 Once the election is made, the electing entity will be taxed on its active trade or business income apportioned to South Carolina at a rate of 3 percent, which is the same rate as the elective flat rate for individuals with trade or business income from a PTE.36 If the electing entity files an income tax return and pays the tax due, the qualified owners can exclude their share of the PTE income from their state taxable income.37 If the qualified owner has active trade or business losses from other PTEs that are reported directly by the owner, those losses may not reduce tax at a rate higher than the elective flat rate.38 The PTE makes the election and the owners’ consent is not required.

V. Considerations in Making PTE Tax Election

A. Are Nonresident Owners Subject to Personal Income Tax Return Filings?

If a nonresident owner’s only connection to a state is through its interest in the PTE, states may view the nonresident owner as having developed sufficient nexus to be subject to income tax in the state. This conclusion is based on the aggregate theory of partnerships under which the partner is deemed to have a direct ownership interest in the assets of the partnership and therefore to be directly involved in the business of the partnership.

If the PTE elects to be taxed at the entity level, and provided the owner has no other connection to the state in which the partnership is filing, will the owner still meet the state’s doing business requirement?

Even though Alabama has issued a proposed regulation stating owners must still file a return post-election and claim a credit for taxes paid, because these elective PTE taxes are new, most states have not provided formal guidance on continued nonresident personal income tax return filing requirements. While Louisiana has clearly indicated it will treat the electing entity as a corporation, it has not stated whether the nonresident owners of entities electing into the PTE will be subject to a personal income tax return filing. In fact, a Louisiana regulation stating that nonresident owners are required to modify the nonresident worksheet of the Louisiana nonresident personal income tax return could imply that a nonresident owner may still need to file a return.39

B. Credit for Taxes Paid by the Entity in an Electing State?

Owners should perform their diligence when reviewing how a PTE tax election made in a nonresident state could affect their resident return. This consideration is especially important when the owners have been taking a credit for the taxes paid to a nonresident state on their resident state income tax return. If the resident state does not provide for a PTE tax election, an owner’s credit for taxes paid is typically based on an owner’s payments and not payments from PTEs. Even if the resident state provides for a PTE tax election, there may still be a risk because some states require the nonresident state’s tax system to be substantially similar. It is still an open question whether a system that allows a credit is substantially similar to one that excludes income on which tax has been paid at the PTE level.

In the states discussed above, the rules are inconsistent, with few providing direct guidance. For example, Alabama has guidance providing shareholders of an S corporation a credit for income taxes paid by or on behalf of the shareholders, including composite and withholding payments, “to any other state in which the corporation is treated as an S corporation.”40 However, Alabama’s proposed regulation states that the tax paid by the PTE is on behalf of the owners.41

While Georgia has not provided specific guidance on the new optional PTE tax elections, the state permits resident individuals who pay taxes in other states to take a credit for those taxes.42 Georgia has historically permitted resident owners of passthrough and disregarded entities a deduction from federal taxable income for the entity’s income subject to a tax based on income in another state.43

Conversely, instead of providing a credit for taxes paid related to the elective PTE tax, Louisiana permits owners who pay another state’s entity-level income tax a deduction from the Louisiana tax liability equal to the owner’s share of any entity-level tax paid.44

C. Accounting for Income Taxes of Publicly Traded Companies?

Publicly traded partners of a partnership making the election to be taxed at the entity level will likely have to follow the Accounting Standards Codification Topic 740, Income Taxes, rules for accounting for income taxes in Alabama, Georgia, and Louisiana. South Carolina will not allow a PTE with a corporate partner to make an election to be taxed at the entity level.

The election is made annually in Georgia and South Carolina, as opposed to being effective until revoked or terminated in Alabama and Louisiana. An entity’s current items will likely be affected in all these states, but the deferred items in Georgia and South Carolina may only be affected if the PTE has the intent and ability to continue making the election annually, absent the states adopting additional rules. However, given that the election in Alabama and Louisiana is effective until revoked, deferred items regarding those states likely will be affected.

VI. Conclusion

While this article summarizes some of the larger issues surrounding the PTE tax election laws in four states, many other states have enacted their own version of a PTE tax election in the past couple of years. Questions abound because the inconsistency of these laws makes owners’ diligence difficult. In addition to the issues discussed above, owners paying tax in multiple states should also consider whether the tax is elective, like the states discussed above, or mandatory, like Connecticut’s PTE tax. Owners also should review the applicable tax rates and determine if they differ from the historic rate. Does the state use the PTE tax base as calculated under the federal income tax rules or does it use a different base as in New York? Further, are there additional forms to file for the election or with the return that affect the administrative burden of compliance? How will the election affect estimated taxes? Will other credits generated by the activities of the PTE continue to flow to the owners after the election?

In addition to the state tax issues mentioned above, it is important to note some federal tax issues that exist that should be layered into the analysis of whether to make a PTE tax election. For example, the limitation on state tax deductions for federal income tax purposes is scheduled to expire for tax years beginning on or after 2026. However, there have been discussions in Congress about whether to eliminate the deduction cap sooner than scheduled. The repeal of the limitation could negate an owner’s motivation for making a PTE tax election. Also, if the proposed regulations mentioned in IRS Notice 2020-75 are issued, how will this affect the viability of the state elections?

These (and other) issues on the state and federal level, along with the lack of sufficient information that PTEs often have with respect to their owners’ underlying tax attributes, will lead to significant complexity and uncertainty as to whether PTE owners will be able to benefit from the PTE tax election. At the very least, PTEs and their owners will have to carefully consider the nuances of the PTE elections available in the southeastern states (and beyond) as a prerequisite to making final decisions regarding such elections.

FOOTNOTES

1 North Carolina has proposed, but not enacted, a PTE tax as of the writing of this article.

2 P.L. 115-97, amending IRC section 164.

4 IRC sections 1361 et seq.

5 Treasury and IRS, Notice 2020-75 (Nov. 9, 2020).

6 At the time of writing this article, 19 states had enacted PTE taxes. Except for the mandatory tax enacted by Connecticut, these taxes are elective.

7 Act 2021-1 (H.B. 170) section 10 (Ala. 2021).

8 Ala. Code Ann. section 40-18-5.

9 H.B. 170, section 10(e).

10 Id.

11 Id. at section 10(f). Taxes include the financial institutions excise tax and all income taxes provided for under Ala. Code Ann. section 40-18.

12 Act 2021-423 (H.B. 588) section 1 (Ala. 2021).

13 H.B. 170, section 10(d).

14 Proposed Ala. Admin. Code r. 810-3-36.1 (proposed Aug. 20, 2021, hearing scheduled for Oct. 5, 2021).

15 Id.

16 Id.

17 Id.

18 Act 164 (H.B. 149) (Ga. 2021).

19 Ga. Code Ann. sections 48-7-21(b)(7)(C)(i); 48-7-23(b)(2).

20 Ga. Code Ann. sections 48-7-21(b)(7)(C)(ii), (v); 48-7-23(b)(3), (6).

21 Ga. Code Ann. sections 48-7-21(b)(7)(C)(iii); 48-7-23(b)(4).

22 Ga. Code Ann. section 48-7-27(b)(16).

23 Act 442 (S.B. 223) (La. 2019).

24 La. Rev. Stat. Ann. section 47:287.732.2.A.(1). S corporations making this election are ineligible for the S corporation exclusion available under La. Rev. Stat. Ann. section 47:287.732.B.(6).

25 La. Rev. Stat. Ann. section 47:287.732.2.F.

26 La. Rev. Stat. Ann. section 47:287.732.2.A.(2). Late elections may be treated as timely if the Louisiana secretary of revenue determines there was reasonable cause for the failure to make a timely election.

27 La. Rev. Stat. Ann. section 47:287.732.2.A.(3).

28 La. Rev. Stat. Ann. section 47:287.732.2.A.(4). The secretary of revenue may terminate the election if the entity shows a material change in circumstances, including a significant change in federal tax law.

29 La. Rev. Stat. Ann. section 47:287.732.2.B. These rates will be reduced for tax years beginning on or after January 1, 2022, if voters approve amendments to Article VII of the Louisiana Constitution at the election scheduled for Oct. 9, 2021. The rates will be reduced as follows: 2 percent to 1.85 percent, 4 percent to 3.5 percent, and 6 percent to 4.25 percent. Act 396 (H.B. 292) (La. 2021).

30 La. Rev. Stat. Ann. section 47:287.732.2.C. If the constitutional amendments are approved by voters at the Oct. 9 election, the deduction for federal income tax will be eliminated for tax years beginning on or after Jan. 1, 2022. Act 396 (H.B. 292) (La. 2021).

31 La. Rev. Stat. Ann. section 47:297.14.A.

32 Act 61 (S.B. 627) (La. 2021); and S.C. Code Ann. section 12-6-545(G)(2).

33 S.C. Code Ann. section 12-6-545(G)(1)(a).

34 S.C. Code Ann. section 12-6-545(G)(1)(b).

35 S.C. Code Ann. section 12-6-545(G)(2).

36 Id. See also S.C. Code Ann. section 12-6-545(B)(2).

37 S.C. Code Ann. section 12-6-545(G)(3).

38 S.C. Code Ann. section 12-6-545(G)(4). See also S.C. Code Ann. section 12-6-545(B)(2).

39 La. Admin. Code section 61:1.1001(C)(4).

40 Ala. Admin. Code r. 810-3-162-.01(5)(a).

41 Proposed Ala. Admin. Code r. 810-3-36-.01.

42 Ga. Comp. R. & Regs. 560-7-7-.01, noting that the District of Columbia (an entity-level tax) is considered a state for these purposes.

43 Ga. Code Ann. section 48-7-27(d)(1).

44 La. Rev. Stat. Ann. section 47:33.A.(7)(a).

END FOOTNOTES

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