Treasury Announces Regulations Blessing State Tax Deduction Workaround for Pass-through Entities

November 10, 2020

By Emily M. Chad and John J. Erhart

As of November 9, 2020, owners of partnerships and S corporations in those states allowing pass-through entities to pay state tax at the entity level can deduct those taxes on their federal returns with the U.S. Department of the Treasury’s blessing.

Under the Tax Cuts and Jobs Act of 2017, Congress limited an individual’s state and local tax deduction on the federal income tax return to $10,000 per year. Corporations, however, are not subject to the SALT deduction limit. States attempted several creative workarounds, and the Treasury quickly shut down the most egregious.

However, in January 2018, Connecticut enacted a law to tax pass-through entities at the entity level (a pass-through entity tax or PET). Tax practitioners posited that, if the entity paid the state tax, it could deduct the state taxes paid against the entity’s federally taxable income. This had the effect of passing the economic benefit of the uncapped state tax deduction to pass-through owners.

Connecticut’s legislation opened the door for several other states to enact similar PET legislation, with one important wrinkle; the subsequent states allowed passthrough entities to elect into the PET. Although practitioners were generally confident these PETs remained deductible, the Treasury announcement and expected proposed regulations from Treasury are a welcome confidence boost.

Treasury’s announcement Monday specified that the proposed regulations will provide that state taxes paid by pass-through entities and described under Section 164(b)(2) are deductible against U.S. federal income taxes, even if the entity could have instead elected to pass through the state tax liability to the entity owners.

Other states with elective PET laws include Wisconsin, Louisiana, Maryland, New Jersey and Oklahoma.

For more information on PETs and their applicability to your business, call a member of Fredrikson & Byron’s Business & Tax Planning Group.