Five More States Enact PTE Tax Elections Legislation – AZ, CA, CO, MN, OR
Five More States Enact PTE Tax Elections Legislation – AZ, CA, CO, MN, OR
Nearly 20 states now allow pass-through entities (PTEs) to elect to be taxed at the entity level to help their resident individuals avoid the $10,000 state and local tax (SALT) deduction limitation known as the “SALT cap” enacted by the Tax Cuts and Jobs Act (TCJA). Since June 2021, Arizona, California, Colorado, Minnesota and Oregon have enacted elective PTE tax regimes. Bills are pending in other states, including Illinois and Massachusetts.
Colorado’s PTE tax regime joins the other “Group 1” states (in which PTE members subtract their distributive share of PTE income from their personal income tax base) and Arizona, California, Minnesota and Oregon adopted “Group 2” regimes – PTE members remain taxable on their distributive share of PTE income, but receive a pass-through tax credit for their share of the PTE tax paid by the entity.
On July 9, 2021, Arizona enacted H.B. 2838 to create an elective PTE tax regime. For tax years beginning from and after December 31, 2021, the partners, members or shareholders of a business that is treated as a partnership or S corporation for federal tax purposes may consent to be taxed at the entity level at a 4.5% rate.
A PTE intending to make the election must notify all owners who are individuals, estates or trusts of the intent to make the election and that those owners have the right to opt out of the election. The notice must allow each of those owners at least 60 days after receiving the notice to exercise their right to opt out. If those owners do not respond within 60 days, or waive their right to opt out, then their distributive share of income will be included in the election.
The election does not apply to owners that are not individuals, estates or trusts. The portion of taxable income attributable to owners that are not individuals, estates or trusts is not included in the PTE’s tax calculation. Thus, the distributive shares of upper tier partnerships, limited liability companies (LLC) or C or S corporations are not included in an electing PTE’s tax base.
The election must be made by the due date, or extended due date, of the PTE’s Arizona return.
The PTE tax is calculated using the entire portion of an entity’s taxable income that is attributable to its resident partners or shareholders and the portion of its taxable income derived from sources within Arizona that is attributable to its nonresident partners or shareholders. Electing PTEs must add back tax imposed by the new law to their federal taxable income starting point, as well as any taxes paid to other states that the Arizona Department of Revenue determines are substantially similar to Arizona’s elective PTE tax.
Electing PTEs whose taxable income for the taxable year exceeds $150,000 in the preceding taxable year must make quarterly estimated payments.
Owners of electing PTEs will receive a credit for their distributive share of tax paid by the PTE that is attributable to the owner’s share of income taxable in Arizona. The credit is not refundable; rather, the credit can be carried forward for five years. Arizona residents are also allowed a credit for tax paid to other states that the Department determines are substantially similar to Arizona’s elective PTE tax. That credit cannot exceed the amount that would have been allowed if the income were taxed at the individual level and not taxed at the entity level.
On July 16, 2021, California enacted A.B. 150. Among various tax changes, A.B. 150 included the “Small Business Relief Act,” which provides a PTE tax election.
Effective for tax years beginning on and after January 1, 2021 and before January 1, 2026, PTEs are provided an annual, irrevocable election to pay tax at the entity level. The tax election is automatically repealed on December 1, 2026. In addition, should the SALT cap be repealed before December 1, 2026, the California PTE tax election becomes “inoperative for taxable years beginning on or after the January 1 after” the federal repeal “and shall be repealed December 1 of that taxable year.”
The election is made on an original return filed by the PTE making the election. Unlike some states, the legislation does not require a majority vote of members (or of the capital and/or profits interests), a managing member or officer to elect or any other PTE governance requirement to make the election.
Election eligibility is limited to a “qualified entity.” A qualified entity must satisfy two requirements: (1) it must be an entity that is taxed as a partnership or S corporation and (2) its partners, members or shareholders must be exclusively individuals, fiduciaries, estates, trusts or corporations (C or S corporations). As a result, a tiered partnership is not a qualified entity under the California PTE tax election rules. Further, a qualified entity does not include a publicly traded partnership or an entity that is permitted or required to be included in a combined reporting group. Thus, the qualified entity requirements could, in some rare instances, exclude S corporations and partnerships from eligibility to make the California PTE tax election.
The California PTE tax is at a rate of 9.3% on the PTE’s “qualified net income,” which is defined as “the pro rata share or distributive share of income subject to tax under Part 10 (commencing with Section 17001) for the taxable year of each qualified taxpayer, as defined in Section 17052.10.” That is, qualified net income comprises the distributive shares of income subject to California personal income tax of the “qualified taxpayers.” A qualified taxpayer means an individual, fiduciary, estate or trust that consented to inclusion of their distributive share of income subject to the California PTE tax, but excludes partnerships as well as disregarded entities. A partner, member or shareholder must consent to have their distributive share of income included in the PTE’s qualified net income subject to the PTE tax. Failure or refusal of a partner, member or shareholder to consent does not invalidate the election, rather, it will simply not be included in the qualified net income calculation.
Starting with tax year 2022, by June 15 of the taxable year of the election, the PTE must make a payment of 50% of the electing tax paid in the previous taxable year, or $1,000, whichever is greater. If the payment is not made, the PTE cannot make the election for that year. There is no such payment requirement for tax year 2021.
A tax credit is provided to the qualified taxpayers of an electing qualified entity, which the qualified taxpayers may credit against the California net personal income tax. The amount of the tax credit is 9.3% of the qualified taxpayer’s distributive share of qualified net income subject to the California PTE tax. Unlike most other Group 2 states that follow the pass-through tax credit regime, the California PTE tax credit is not refundable. If the credit exceeds a qualified taxpayer’s net personal income tax, the excess is carried forward to the following tax year and the succeeding four tax years. Similar to the PTE tax election, the tax credit provision remains in effect only until December 1, 2026, when it will be treated as repealed. It is unclear how any excess tax credit remaining will be treated.
Should a PTE make the California PTE tax election, the PTE tax is in addition to any other taxes imposed on the PTE, including the California minimum franchise tax, LLC tax and LLC fee.
On June 23, 2021, Colorado enacted H.B. 21-1327, known as the SALT Parity Act, to allow PTEs the option to be taxed at the entity level.
For tax years commencing on or after January 1, 2022, partnerships, S corporations and LLCs treated as partnerships or S corporations (electing PTEs) are eligible to make a PTE tax election. An electing PTE owner does not include a C corporation that is unitary with the partnership. The annual election is binding on electing PTE owners and is made on the electing PTE’s tax return.
Similar to California’s PTE tax election, the Colorado PTE tax election is only allowed in an income tax year when the SALT cap is in effect for federal tax purposes (i.e., tax years ending on or before December 31, 2026, or earlier if the federal SALT cap is repealed sooner.) The tax rate for electing PTEs is 4.55%. The tax base is the sum of each electing PTE nonresident owner’s pro rata or distributive share of the electing PTE’s income attributable to Colorado and each resident electing PTE owner’s pro rata or distributive share of the electing PTE’s income from all sources.
Credits attributable to the electing PTE’s activities must be claimed at the entity level, and they cannot be passed through to the owners. Additionally, excess net operating losses, income tax credits or other modifications must be carried forward on the electing PTE’s return and can only be used in a year in which a PTE election was made. Electing PTEs can also claim credits for taxes paid to other states on income not attributed to Colorado. This income must be subject to entity-level tax in other states, and it can have been paid to other states by the electing PTE itself or by the electing PTE owners.
Electing PTE owners subtract from their federal taxable income (FTI) starting point their distributive share of the electing PTE’s income. They must also add back the qualified business income deduction allowed by Internal Revenue Code (IRC) Section 199A, unless that deduction was disallowed by IRC 265.
Typically, nonresidents are required to file a nonresident tax return that includes their portion of income earned in Colorado. However, a nonresident individual, whose only source of income in Colorado is from an electing PTE, is not required to file a Colorado personal income tax return.
Minnesota enacted H.F. 9 on July 1, 2021, allowing PTEs the option to be taxed at the entity level. Minnesota’s new PTE tax election is applicable to tax years beginning after December 31, 2020, as long as the federal SALT cap is in effect.
Under H.F. 9, partnerships, LLCs and S corporations (including qualified subchapter S subsidiaries) are “qualifying entities” eligible to make the election. Qualifying entity does not include a partnership, LLC, or corporation that has a partnership, LLC other than a disregarded entity, or corporation as a partner, member, or shareholder.
The election to be taxed as a PTE is irrevocable, and it must be made annually by the due date of the qualifying entity’s PTE tax return, including any extensions. The election must be made by “qualifying owners” (resident or nonresident individuals or estates that are partners, members or shareholders of a qualifying entity, or residents or nonresident trusts that are shareholders of a qualifying entity that is an S corporation) that collectively hold more than a 50% ownership interest in the qualifying entity. Once made, the election is binding on all qualifying owners.
The tax base is equal to the sum of the tax liability of each qualifying owner. The tax rate for electing PTEs is highest individual tax rate, which is currently 9.65%. When making this determination, nonbusiness deductions, standard deductions or personal exemptions are disallowed. Additionally, credits and deductions are allowed only to the extent allowed to the individual owner.
Minnesota provides a credit to each of the qualifying owners of an electing PTE equal to the amount of each owner’s PTE tax liabilities. If the amount of the credit exceeds an owner’s tax liability, the excess is refundable to the owner.
On July 19, 2021, Oregon enacted S.B. 727. An eligible PTE, which is a partnership, LLC or S corporation (if all members are individuals or other PTEs owned only by individuals and are subject to Oregon personal income tax), may elect to be subject to the “pass-through business alternative income tax.”
The election is an annual election that must be made on or before the due date of the PTE’s tax return, including extensions. It is made by any authorized officer, manager or member of the PTE, but all members must consent to the election. Oregon allows a revocation of the election for a tax year, if made on or before the due date for the tax year’s PTE return and if all members consent.
The pass-through business alternative income tax base is the “sum of each member’s share of distributive proceeds attributable to the” PTE for the tax year. “Distributive proceeds” mean the PTE’s “net income, dividends, royalties, interest, rents, guaranteed payments, and gains” that are derived from or connected to sources within Oregon. When calculating the tax base, the PTE is required to add-back any Oregon pass-through business alternative income tax deducted for federal tax purposes under IRC Section 164(b)(6).
The tax is calculated using a graduated structure: a 9% tax rate is imposed on the first $250,000 of the PTE’s distributive proceeds, and a 9.9% rate is imposed on the PTE’s distributive proceeds in excess of $250,000. However, S.B. 139, also enacted on July 19, 2021, changes the tax rates for members that materially participate in the trade or business, which could impact members of an electing PTE.
The PTE must report to each member their share of distributive proceeds and share of PTE tax paid. Members receive an Oregon personal income tax credit for their pro rata share of Oregon PTE tax paid. The credit is refundable.
The Oregon PTE tax election is currently only effective for tax years beginning on or after January 1, 2002, and before January 1, 2024 (limited to the 2022 and 2023 tax years). Similar to California and Colorado, it is also automatically repealed should IRC Section 164(b)(6) be repealed for federal tax purposes.