Understanding Pass-Through Entity Tax (PTET): A Comprehensive Guide for Multi-State Businesses

The Pass-Through Entity Tax (PTET) is designed for pass-through entities like partnerships, S corporations, and some limited liability companies (LLCs). These entities typically pass their income and deductions to owners or shareholders, who report these on individual tax returns.

It’s a great way to effectively bypass the State and Local Tax (SALT) deduction limit cap of $10,000. This is because qualifying businesses can pay state tax, rather than their owners or shareholders. 

As such, PTET can provide a great tax planning opportunity if your business operates across state lines. However, electing PTET means you’ll need to comply with a number of regulations, and this may differ depending on where your business is located. 

In this blog, we’ll help you understand PTET to minimize your tax burden. 

Basics of Pass-Through Entities

In a nutshell, a pass-through entity is a business structure that is legally considered the same entity as the individual who owns it. As such, it is taxed at individual income tax rates and reports all income on an owner or shareholder’s individual income tax return. PTET therefore affects the following business entities:

Single-member LLCs (SMLLCs)

An SMLLC is considered a disregarded entity for federal tax purposes, meaning that its income is reported on the owner’s personal tax return. They are generally required to make quarterly estimated tax payments by a certain date, via Form 1040-ES, and Schedule C of Form 1040.

Note that PTET is not available to single owners of SMLLCs. For SMLLCs to participate, you’ll need to admit an additional owner. 

Partnerships

These are formal business arrangements between two or more parties to jointly manage a business, and share profits and liabilities. However, how this is taxed depends on whether you’re an active or passive partner.

Partnerships are not taxed at entity level. Instead, profits flow to partners, and are reported on their individual tax returns, through Schedule K-1 and Form 1040-ES.

S Corporations (S Corps)

S Corps are not taxed at entity level. Instead, profits flow to shareholders, and are reported on their individual tax returns, using Form 1120-S​. S Corp owners must also be paid reasonable market compensation for their roles, and must make estimated tax payments.

Tax Treatment of Pass-Through Entities

When a pass-through business entity makes a profit, it flows through the business and onto the owners’ tax returns. As such, the owners rather than the entity itself report these profits to the IRS. Each owner must also include their portion of the entity’s net income or net earnings on their return, in order to determine their liability. 

Pass-through entities must also pay state and local taxes (SALT), as well as self-employment taxes, which include Social Security and Medicare. And if your business has employees, you’ll need to calculate their payroll liability, too. 

The main benefit of pass-through entities is that they help your business avoid double taxation, because you’re not taxed at an individual and entity level. For example, C Corp owners do not have this luxury – they’re taxed at a 21% corporate rate, and shareholders are also taxed on any money they take from the business. 

Another notable advantage is that pass-through entities can report a net operating loss (NOL), to lower the owner’s personal tax liability. Basically, as an owner, you can apply for a NOL deduction. 

Understanding PTET

PTET is basically a state’s mandatory or elective entity-level income taxation on pass-through entities. Each state has its own way of calculating the tax, but it boils down to the amount you’d pay at the individual level, if your income was passed through. 

PTET was introduced after a group of states unsuccessfully tried to sue the federal government, Treasury, and the IRS. These states claimed that SALT deduction limits were unconstitutional. Instead, they proposed a new way to tax pass-through entities, and PTET was created. While some states can elect to adopt PTET, others have made this form of tax mandatory. 

The goal of PTET is to reduce your business’ ordinary income by the amount of income tax paid. This means that owners, partners, members or shareholders will have lower federal income, and won’t pay state taxes on business income. Instead, you’d get a refundable credit against your state personal income tax, or you can subtract business income from your normal state income.

How it works

Under this scheme, state tax payments are basically converted into deductible business expenses. You see, a state will impose a tax rate on any income derived within its borders. But under PTET, this is paid to the state through your company’s tax return and thereafter, a credit is listed on your partner’s or shareholder’s K-1. 

This credit offsets any tax you may owe at the individual level, before you pay whatever you owe. If you have an overpayment, you’ll either be credited for the following year, or receive a refund.  

But how much are you saving, exactly? As an individual taxpayer, you will save the amount of the credit, multiplied by your federal tax rate. 

States Implementing PTET

There are currently 36 states that have elected PTET. Connecticut was the first to do so in 2018. Since then, the following jurisdictions have followed suit:

However, it’s important to remember that each state has its own rules regarding the implementation of PTET and its associated tax rates. Nevertheless, here’s a brief overview of some of the state-specific rates and election requirements:

Many states have tax rates with varying ranges, similar to New York. To verify the exact rate, it’s best to confirm directly with the state department in question. 

Advantages of PTET

There are a few advantages to PTET. Topping the list is the ability to avoid the $10,000 SALT deduction cap. In addition, the tax isn’t subject to the alternative minimum tax (AMT), which provides even more benefits. 

For instance, avoiding the AMT means your business can maximize the PTET deduction without worrying about limiting your ability to claim other deductions. It also means that you’re less likely to face a higher tax rate, which can reduce your overall tax liability. As such, your tax planning and financial forecasting will be simplified.

Despite the upsides, there are still a few concerns associated with PTET. 

Challenges and concerns

Even though the scheme appears to have a number of benefits, that’s not always technically the case. For example, the costs associated with electing PTET – from admin to compliance, or consulting a professional – might outweigh your potential savings. 

In addition, PTET payments must be trued up, or calculated accurately. Basically, what you expect to pay is estimated throughout the year, before a final calculation is made at the end of the tax year. Then, these amounts need to be reconciled and adjusted, to be as accurate as possible. If your calculations aren’t accurate, you may lose the benefit of avoiding double taxation. 

Because states have also implemented their own rules and rates for PTET, if your company works across multiple borders, you will need to make separate calculations and follow different compliance regulations for each state in which you conduct business. 

And there’s an added complication if your S Corp or Partnership has varying rules for allocating profits. At the federal level, taxable income is allocated according to your profit share, as laid out in your partnership or operating agreements. While states should follow the federal rules on this, because of differences between their rules, having disproportionate profit sharing could affect your filings. 

How PTET Affects Multi-State Businesses

Generally, if your business is limited to a single state, PTET calculations and procedures are pretty straight-forward. As mentioned above, the challenges come in for companies who operate in multiple states, especially if the owners reside in different states. 

After all, states generally use federal taxable income as a starting point and adjust this based on individual state tax rules. But if those rules differ, so too will the adjustments. In fact, some states differ on exactly what income is subject to PTET. 

Moreover, some allow the resultant credits to be taken at a business level, while others insist it be used at an individual level. Even more complicated, states like New York allow you to get a refund for the credit, while other jurisdictions like California only let your business carry the credit forward to the next tax year. 

These kinds of considerations make it essential to have a proactive management strategy in place for PTET payments. 

Best Practices for Managing PTET

To make the most of PTET benefits, you must ensure that your business complies with all the requirements, in every state in which you operate. This includes staying up to date with regulations and laws, and any changes made. It also means you’ll need to have detailed and accurate records to ensure that all your reporting is compliant and accurate, and that you can provide evidence of any claims made. 

And as always when it comes to handling taxes, when in doubt, consult a professional. A tax expert can make sure that your business is not only compliant with any PTET regulations, but also maximizes the potential benefits through proactive planning and strategy. 

For help navigating your business’ PTET obligations, or for more information, schedule a Discovery Call with one of our CPAs. 

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