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Contractors organized as a pass-through entity (PTE) may be eligible for a sizeable federal income tax benefit on their personal tax returns stemming from a newly created state and local tax (SALT) deduction.
In recent years, a considerable number of states – including Ohio, West Virginia, New York and Maryland – have enacted legislation allowing for such a deduction, which benefits individuals who pay state income taxes in those jurisdictions. With proper planning and tax benefit modeling, businesses can take advantage of the federal tax savings associated with this opportunity.
A PTE is organized as a partnership, an S corporation or an LLC taxed as either a partnership or an S corporation and is owned – directly or indirectly – by at least one individual, estate or trust. Income is generally passed through to the individual and not taxed at the entity level.
The Tax Cuts and Jobs Act of 2017 (TCJA) created an annual limit of $10,000 on the amount of state and local income tax payments that individuals could deduct for federal income tax purposes (known as the “SALT cap”). Prior to the TCJA, there was no annual limit. In response, 36 states have since created an election to impose state PTE tax at the entity level, as opposed to flowing income through to be taxed on an individual’s federal return.
Because there’s no SALT cap on the amount of state income taxes an entity can deduct, the electing entity’s federal income tax is reduced by the full amount of state and local income taxes paid. The benefit of the state election is passed along to the individual, either by exclusion of income from the individual’s federal income tax return or through a tax credit equivalent to the tax paid by the entity. As a result, the individual receives the federal benefit for state taxes paid as if there was no SALT cap in place.
Requirements vary, depending on the state, and the business structure and location of owners may impact whether the election is beneficial. The level of income generated by each business needs to be considered as well, since some states utilize inconsistent tax rates at the entity and individual levels.
Contractors operating in states where the PTE tax deduction is available may benefit from the election, but a number of factors must be considered, including those mentioned above and a host of other technical considerations. Therefore, careful consideration is required when reviewing whether to make the election, to avoid unintended consequences.
The Schneider Downs SALT practice is equipped to help you evaluate the benefits of PTE elections and to assist you in the mechanics of making the election. Please direct your inquiry to Stephen Worth, State & Local Tax Practice Leader, at [email protected].