Would Indiana’s New Pass-Through Entity Tax Save Your Company Money?

Indiana has joined 30 other states with a pass-through entity tax (PET) regime in response to the limited state and local tax deduction on individuals’ federal income tax returns.

Indiana recently enacted a bill that allows PET regimes for tax years beginning after December 31, 2021. As a result of the “retroactive” legislation, pass-through entities with tax years beginning in 2022 and forward may elect Indiana’s PET regime (e.g., for calendar year taxpayers, the election can be made for the 2022 tax return).

This is in reaction to the 2017 federal Tax Cuts and Jobs Act, which limited the state and local tax deduction on individuals’ federal income tax returns to $10,000 a year. By making the PET regime election, the Indiana income tax expense is moved to the entity level where there is no $10,000 limit.

A pass-through entity taking the deduction reduces the amount of distributable net income passed through to the owner, so the owner’s federal income taxable income and resulting federal tax liability is, in effect, reduced. This election provides a significant federal income tax benefit to owners of pass-through entities doing business in Indiana, with essentially no effect on their Indiana personal income tax liability.

Following is an illustration of the benefits of a PET election. In this example, assume Company A is a pass-through entity (e.g., partnership or S corporation) and has both Indiana resident and nonresident individual owners, owning 50%/50%. Assume the Indiana apportionment percentage is 4% and the PET rate is 3.23%.

Without the PET election

Company A must pay the Indiana income tax “on behalf” of all its nonresident owners (i.e., a composite tax) with respect to Indiana sourced income (i.e., 4% of the company’s income). The tax that is paid by Company A, as a tax payment on behalf of the nonresident owners, is treated as a distribution to them and is subjected to the $10,000 limit on the nonresident individual owners’ Form 1040. The resident owners must pay their own tax directly to the state, again subject to the $10,000 limit. As a result, the owners of Company A receive little to no federal income tax deduction if the taxes are paid without a PET election.

With the PET election

By making the PET election, the tax is imposed directly on Company A and is treated as a deductible state income tax expense of Company A (not a distribution for tax purposes). The entity level tax is imposed on both the residents’ and nonresidents’ distributive share of income passed out to them. (For 2022, the PET election must be made between April 1, 2023, and August 30, 2024. For subsequent years, the election must be made by the due date of the pass-through entity’s Indiana tax return.)

Company A pays PET on the nonresident owners’ Indiana-sourced income and on the resident owners’ income. With respect to resident owners, there is an option to pay the PET on 100% of Company A’s income attributable to the resident owners or only on the Indiana sourced income attributable to the resident owners.

Under Option 1, Company A can deduct $16,796. Under Option 2, Company A can deduct $1,292. This is the deduction that provides the owners with a federal income tax benefit.

	Option 1	Option 2
	Residents	Residents
Total income	$1,000,000	$1,000,000
Ownership %	50%	50%
Owners share of income	$500,000	$500,000
Indiana %	100%	4%
Taxable	$500,000	$20,000
Indiana tax rate	3.23%	3.23%
Resident tax	16,150	646
Nonresident tax	646	646
Total PET	$16,796	$1,292

To alleviate double Indiana taxation on the same income (tax paid by Company A and again when paid by the resident and nonresident owners when the income passes through to them to be taxed), the owners receive a credit for their share of the tax that was paid by Company A.

As a refundable credit, if the owner’s PET credit exceeds the owner’s Indiana tax liability, the excess will be refunded. (Generally, the owner is not again subject to tax on the income that was already taxed at Company A’s level. The owners receive a benefit as if they paid the tax.)

A resident will be required to file a return and claim the refundable credit. The PET filing will fulfill a nonresident’s filing requirement if the pass-through entity income is the only income in Indiana. If the nonresident files a personal Indiana return, the nonresident will receive a refundable credit for their share of the PET paid.

Indiana resident credit for PET paid to another state

With or without the election, Indiana resident owners of pass-through entities that file other state returns paying similar PETs to other states can now benefit. In the past, Indiana owners could not take a credit for PET paid to another state against their Indiana personal income tax liability. This created double state taxation on the same income (taxed in the other state and Indiana).

Illinois is one of those states. Under the existing law, although a pass-through entity could take a federal income tax deduction for the Illinois elective PET, the owners would pay state income tax in both Illinois and Indiana on the same income. Under the former law, the Indiana resident owners would not be able to claim the credit for taxes paid to Illinois because the tax was imposed directly on the pass-through entity and not directly on the owner. If the company did not make the PET election in Illinois, the company would miss out on the federal deduction.

Under the new law, if a pass-through entity makes a PET election in another state, a resident owner can now claim the other state PET to calculate a credit for taxes paid to another state. This allows the owner to avoid the double state tax on income.

Concerns

The election is not eligible for all types of owners. The current wording of the law allows the Indiana Department of Revenue to issue guidance on what owners are ineligible. Also, considering the law was just enacted, the state has not at this time issued specific guidance with respect to making the election or paying the PET.

Since this law was recently enacted, consider extending your Indiana partnership or S corporation return to allow more time to analyze the consequences of this new law. Be mindful of the election period. The Indiana Department of Revenue is addressing the mechanics of making the election and filing a pass-through entity return using the current forms so that minimal programming changes will need to be made to their systems.

How we can help

Contact our Indiana tax team to discuss if the Indiana PET election is right for your company. Also, give additional consideration in scenarios where PET elections in other states are available. It may be much more favorable for pass-through entities with Indiana resident owners to make the election in other states and claim the resident credit.