Know the Differences Among State Pass-Through Entity Taxes ("PTETs")

With the enactment of the Tax Cuts and Jobs Act of 2017 (“TCJA”), individual taxpayers were limited to a $10,000 state and local tax deduction per year. In response to this limitation, many states created a workaround mechanism, introducing a pass-through entity tax (“PTET”). This shifted the state and local tax deduction from an individual taxpayer to the entity level that is not subject to the $10,000 limitation.

Connecticut was the first state that enacted a PTET in 2018, making it mandatory. In November 2020, the IRS issued Notice 2020-75, which allows a state tax deduction at the pass-through entity level. The guidance opened the floodgates to states enacting a PTET, resulting in approximately 31 states that currently have a PTET in place. While many states have a PTET, the rules vary on a state-by-state basis.

One of the main differences among the various PTET regimes concerns who can claim the PTET credit and whether such credit is refundable. For example, in New York, only individuals, estates and trusts may claim a refundable credit for taxes paid by the entity. Other states, such as Illinois and Maryland, consider all types of members, including corporations and other pass-through entities eligible for the PTET credit. Some states imposed a limitation on the amount of PTET credit a member is entitled to claim: 87.5% and 90% in Connecticut and Massachusetts, respectively. As there is no conformity among states, taxpayers and tax professionals must consider each state individually to quantify the benefits of the PTET to evaluate their particular situation. Let’s explore some of the key differences in the PTET world using Illinois, South Carolina and New Jersey as examples.

Illinois Pass-Through Entity Tax (“IL PTET”)

Illinois enacted a PTET in 2021 that allows partnerships, S corporations and LLCs to make a PTET election on an annual basis. The election is due by the original due date of the entity’s return or extended return. The election cannot be made on an amended return. Illinois is unique because it allows an entity two methods of calculating the PTET credit.

One method treats the entity as an investment partnership for IL PTET purposes, and all its income is subject to the PTE. For example, an entity with no state source income that only has interest/dividends/capital ^gains[1] would be subject to the IL PTET on this income.

The other method is based on net income allocable to Illinois (Illinois source income). The net income method disallows certain items, such as the standard exemption, the net loss deduction, and the deduction for income distributable to shareholder/partner subject to replacement tax, among others.^[2]  

Different from New York and California, there is no concept of a resident versus non-resident pool. All investors in the entity for IL PTET purposes are included in the PTET taxable income. The tax rate is 4.95% for all investors regardless of entity type. Thus, for corporate and trust taxpayers, an underpayment may result due to the differential tax rates that apply to such entities. The Illinois tax rate is 9.5% for corporations and 6.45% for trust taxpayers. Entities in a tiered-structure are eligible members for the IL PTET, and the upper-tier member getting the PTET credit may apply the credit at its level or distribute the credit to its members. The upper tier is not required to make a PTET election to distribute a credit to its members.

Other benefits of the IL PTET include:

• The credit is refundable.
• Non-resident withholding requirements do not apply.
• Non-resident individual partners may not be required to file an Illinois non-resident income tax return if the credit equals or exceeds their Illinois income tax liability.
• A resident state tax credit is granted to taxpayers for pass-through entity taxes paid to other states that are deemed substantial (e.g., NYS, CA, NJ).
• Guaranteed payments are included in the PTET taxable income.

The Illinois replacement tax, an entity level tax of 1.5% imposed on certain taxpayers, is still in place regardless of whether an IL PTET election is made. An electing entity must make estimated quarterly payments if a liability of $500 or more is expected. For a calendar year partnership, estimated tax payments are due on April 15, June 15, September 15 and January 15 of the following taxable year. For a calendar year S corporation, the first three payment dates are the same, but the fourth estimated payment is due on December 15.

South Carolina Pass-Through Entity Tax (“SC PTET”)

South Carolina enacted a PTET in 2021 that allows partnerships, LLCs and S corporations to make an annual election by the original or extended due date of the entity’s return. A qualified entity is one that is comprised of all its investors that are individuals, estates, trusts or any other entity except tax-exempt entities (e.g., IRC Section 501 through 528, IRC 1321 (cooperatives), banks, insurance companies, nonprofit corporations).

The SC PTET election is more restrictive because it is only available to entities that solely generate active trade or business income. The SC PTET tax rate is a flat 3%. A passive entity generating only interest/dividends/capital gains may not necessarily qualify for the SC PTET. South Carolina residents should carefully consider whether a PTET is viable because the PTET credit is based on South Carolina source income, and it excludes entities that do not generate business income that is allocable/apportionable to the state.

Other SC PTET benefits include:

• Any overpayment of PTET tax paid by the pass-through entity is refunded to the pass-through entity or carried-forward to the subsequent year.
• A qualified owner shall exclude active trade or business income from an entity that elected to the SC PTET.
• Non-resident withholding is not required for qualified owners that are included in a SC PTET electing entity.^[3] However, qualified owners may still require South Carolina estimates to be paid to the extent the pass-through entity has both active trade or business income and South Carolina sourced passive income. This is because passive income is not included in the South Carolina pass-through entity tax computation.

Starting in 2022, electing qualified entities must pay estimated taxes on April 15, June 15, September 15 and January 15 of the following taxable year for calendar-year taxpayers. [4]If the electing entity fails to pay estimated taxes, the South Carolina Department of Revenue may collect the amounts from the electing entity or its direct or indirect owners or both.

New Jersey Business Alternative Income Tax (“NJ BAIT”)

States are continuously updating their PTET rules. A state that recently amended its law to make the PTET more attractive to taxpayers is New Jersey. When the NJ BAIT was first enacted, the credit was computed based on New Jersey sourced income for all investors in a partnership regardless of residency status. The NJ BAIT credit was non-refundable to corporate members, and the NJ BAIT overpayment could only be carried forward to 2022 provided a NJ BAIT election was made for tax year 2022. On January 18, 2022, Governor Murphy signed S4068, which revised the NJ BAIT tax base for resident partners in a partnership. The revised base includes all income subject to gross income tax for resident members that are individuals, estates or trusts whether New Jersey sourced or not. S corporations’ NJ BAIT base continues to be based solely on NJ sourced income for all members.

Starting in 2022, entities are not required to withhold on non-resident members that expect refunds due to their BAIT credit.[5] In 2021, S corporations were allowed to apply either the corporate rules (market-based sourcing/single-sales factor) or the partnership rules (cost-of-performance sourcing/three-factor apportionment) when computing their NJ BAIT credit. However, in 2022, S corporations must use the partnership apportionment rules to compute New Jersey sourced income for NJ BAIT purposes and must use the corporate rules for calculating their NJ distributive shares for shareholders.

Finally, in a tiered-structure, the upper-tier member receiving a NJ BAIT credit is not required to make an NJ BAIT election at its level to distribute the credit to its members or apply it at their level against other taxes, such as NJ non-resident withholding, NJ filing fees or the BAIT. This differs from 2021 where the upper tier was only able to apply any BAIT credit it received from a lower tier against its NJ non-resident withholding.

[1] Publication 129, Pass-Through Entity Information, 03/01/2022

[2] ILCS Chapter 35 §5/201(p)(3)(A)

[3] S.C. Code Ann. §12-6-545(G)(6)

[4] S.C. Code Ann. § 12-6-3910(A)(3)(a)

[5] https://www.state.nj.us/treasury/taxation/baitpte/index.shtml