PTET

You are limited to deducting $10k in property, sales, or income taxes already paid to state and local governments.

However, there is a work around for business owners that allows you to deduct significantly more.

We work with some business owners where this saves them $10k-$50k in taxes per year

Here’s what you need to know about PTET:

The pass-through entity tax election (PTET) is one of the more impactful tax strategies available to business owners. Every business owner with a pass-through entity should be generally aware of this election and how it interacts with their situation.

This blog aims to shed light on the key aspects of the Pass-Through Entity Tax, explaining what it is, who can benefit, and how businesses can leverage this tax incentive.

What is Pass-Through Entity Tax Credit (PTET)?

Pass-through entities, such as partnerships and S corporations, don't pay income taxes themselves. Instead, their income "passes through" to the owners, who report it on their individual tax returns through a Schedule K-1. 

In 2017, The Tax Cuts and Jobs Act of 2017 placed a cap on state and local taxes of $10,000. This is usually referred to as the SALT cap. It limits the deduction an individual is allowed to claim on their personal return for state and local taxes paid throughout the tax year to $10,000. 

In an attempt to mitigate the adverse effects of the SALT cap, the Pass-Through Entity Tax (PTET), an optional election that taxpayers can use, was introduced in certain states. 

The PTET is a tax on pass-through entities. The paid amount of tax then reduces the business’ ordinary income by that amount. This is similar to any other ordinary business expense that you would normally deduct. Now, the impact of this is two fold:

- First, direct partners, members, and shareholders receive a refundable credit against their personal state income tax liability in the amount of the tax paid (allocated proportionally based on ownership) or they will reduce their state income by their business income (also based on their respective ownership)

- Second, as a result of paying this credit, the business has a lower ordinary income, therefore, when that income passesthrough to partners or shareholders they have effectively reduced their income for federal taxes, as well. This was the point when we talked about maneuvering around the SALT cap. 

A tertiary point to quickly mention is that PTET is not subject to alternative minimum tax (AMT). AMT usually is levied on SALT deductions, but it is not on PTET. 

PTET in Practice

To give a very basic example of how this may work for your business, consider the following hypothetical scenario. We’re not going to consider any other deductions or credits and just focus on PTET.

Fred lives in Illinois where he owns a widget factory. Fred’s personal home’s property taxes exceed $10,000, so he’s not able to recognize any additional tax deduction from his state and local taxes on his federal return. The widget factory is an S Corporation and he elects into PTET for the current tax year. 

Fred had a net profit of $1,000,000 the prior year and he expects to profit the same amount in this current year. The PTET rate in Illinois is 4.95%. Because he anticipates his tax liability to exceed $500, his S Corporation has made timely estimated tax payments as required by the state each quarter. This would amount to $12,375 each quarter (we’re not going to account for IL Corporate Replacement Tax in this example).

By year-end, Fred was right. He profited exactly $1,000,000 not including his PTET payments. His S Corporation is able to deduct the tax payments that he made for PTET lowering his ordinary income by $49,500. He would report his ordinary income of $950,500 on his personal tax return. Then, on his personal state return, he would recognize a state income tax credit of $49,500 for the tax his business paid in the same year. 

The result of PTET is that he was able to deduct nearly $50,000 additional dollars that he would not have been able to federally had he not elected into PTET. He would have otherwise recognized $1,000,000 of ordinary income and the deduction from paying those state income taxes would have been lost for the year. Assuming Fred stays in the 37% tax bracket, this would yield a little over $20,000 in tax savings for the year when the state’s income taxes are considered, as well. 

This is a very rough example, but it makes two key points. The first is that PTET is an effective means of lowering your overall federal tax burden in ways that you are usually unable to do, and second, that each state has specific rules that you must follow. Illinois is just one specific example and we touched on a few things in the example. The payment of estimated quarterly taxes would be a key consideration that if not adhered to would have resulted in penalties - in turn, the strategy becomes much less effective. 

PTET Limitations

Keep in mind that each state has its own rules for PTET. We’re not going to get into the intricacies of each state in this post. Additionally, while you may find PTET straightforward, in practice it is often anything but that. Work with a tax professional to make sure that the election is filed correctly and timely.

Here is a list of states that have PTET laws, those that have drafted pending legislation, and those that do not have state income taxes: Link.

PTET is not something you want to elect into on a whim. As an owner or partner, it is crucial you fully understand the calculation of the tax in your state and the effects at the entity level and the individual level. Many states typically will not allow the filing election to be revoked once you make the choice to opt in. All of this is doubly true when you are dealing with an entity that has multiple owners in multiple states. Do not fall into the trap of potentially losing the benefit or potentially being taxed twice, once at the entity level and then again on the personal level.