Election counts with Transfer Entity Tax Elections

A majority of states promulgated tax on intermediate entities laws, allowing partnerships and S corporations to elect to pay entity-level state income taxes that are deducted from federal taxable income earned by owners of flow-through entities. Depending on whether the PTE is a partnership or an S corporation, a PTET status could offer a greater tax advantage.

State laws are not always consistent when determining the tax base of resident and non-resident owners, and they may differ more regarding which owners are eligible for the PTET deduction.

Due to varying rules imposed by states, there could be significant federal and state tax consequences, depending on the residency of PTE owners combined with the language contained in the PTE’s legal documents.

Invalidation of a federal election S Corporation

S corporations require income, deductions, and distributions to be based on proportionate ownership. If the IRS finds that the income and deductions were not prorated, the agency could invalidate Election S and the entity would revert to a taxable C corporation. Therefore, before making a TFWP Election, S Corporation shareholders should understand the impact of the deduction on their income and deductions.

In some states, a PTET election may have a disproportionate impact on S corporation owners, particularly if the ownership group includes people who reside in different states or when the owners are not included in the PTET record. It is therefore possible that a PTET election inadvertently invalidates the federal election S, causing him to lose the status of PTE and the possibility of making a PTET election. An invalid Election S creates a host of other federal and state tax complications in addition to TFWP eligibility.

These consequences can be avoided through careful planning and documentation of distributions to owners and payments that shareholders make to the company. Partnerships, on the other hand, will not lose PTE status because partnerships are not required to allocate income, deductions, and distributions on the prorated ownership share.

Impact of State Allocation on PTE Benefits

In general, if a PTE only operates in one state, the type of PTE will not have a significant impact on the benefits owners receive, as 100% of the income would be included in the TFWP base. But if a PTE is taxable in multiple states, the full benefit of the PTET deduction may not be received. State rules vary widely when it comes to determining the tax base to which the TFWP applies.

For S corporations, some states only include the income in the tax base to the extent that it is from an activity carried on in the state. In this case, all of a resident owner’s state tax liability would not be covered by the deducted TFWP. Here, the resident owner would be taxed on 100% of his distributable income on his individual return, while the PTE would only pay tax on the amount allocated to the state. Other states will look at the residency of PTE owners. For resident PTE owners, the tax base would include 100% of their income. For non-residents, the tax base would only include income attributed to the state.

S corporation rules require that income and expense items be allocated to shareholders on a pro rata basis. Because of this requirement, some state laws will cause shareholders to receive federal deductions on income earned by other owners. This is due to the different income allocation or attribution rules for non-resident and resident owners. The benefits of the TEP could also be impacted for partnerships, depending on whether or not there are special allowances for allocating income and expenses to partners.

Who owns the PTE?

The PTET election was created by the states to give individuals a way to deduct state income tax from their federal income. Election and reporting are less complex when done by a partnership or a wholly privately owned S corporation. However, many partnerships have ownership groups that include other PTEs, C corporations, and trusts.

In some states, the existence of PTE owners or C corporations may render the PTE ineligible to stand for election to the PTET. In states where tiered TEWPs are permitted, the attribution of the TFWP benefit and tax base becomes more complicated because the paid TFWP must be passed on to the ultimate owner, individual or corporation. This information is often unknown and the ultimate owner may not be eligible to claim the PTE deduction or related credit.

Who elects the PTET?

Partners and shareholders may be negatively affected if tied to the election, and action may be required to make these PTE owners whole. Rules vary when it comes to making the election, and not all states require all or most PTE owners to agree to the election for it to apply.

Partnership agreements and other legal documents may need to be amended to address inconsistencies in state law. It may be necessary to write separate provisions in agreements that specifically address the allocation of the TFWP deduction among owners.

Key points to remember

When a PTE is considering a PTET election, or a new business is seeking information on choosing the entity based on PTET options, the decision requires careful analysis of many factors. Make sure those involved in the decision consider:

  • Ensure that a Company S election will not be invalidated by making the PTET election.
  • How state distribution rules can affect the benefits of a PTET election.
  • Who owns the PTE, as some states do not allow certain owners to make a PTET election.
  • Who needs to be involved to do the PTET election.

If you have any questions about the impact of a TFWP election, whether in your role as an officer of a flow-through entity or as an entity owner, please contact your tax advisor to discuss the facts and specific circumstances of your situation.

This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Tony Israels leads the Local and State Tax Due Diligence Group of the Plante Moran National Tax Office. He has clients in manufacturing, service industries and private equity.

Jason Parish is a partner in Plante Moran’s National and Local Tax Group. He works in all areas of SALT, including income/franchise taxes, sales/use, and gross receipts, primarily in the service, manufacturing, and distribution sectors.

Ron Cook is the national practice leader of Plante Moran’s national and local tax group. He helps clients stay abreast of tax issues that impact their business and navigate the complexities of state and local taxes.

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