- Many state jurisdictions are now allowing or requiring pass-through entities to calculate and pay tax at the entity level. Different characteristics of the many taxing regimes can cause complexity when determining if these entity-level taxes should be accounted for in accordance with FASB Topic ASC 740.
- For proper financial statement reporting, give careful consideration to how each jurisdiction’s rules apply to an entity.
Not sure if your potential entity-level taxation may require U.S. GAAP considerations?
Pass-through entities electing to pay tax at the entity level may need to consider U.S. GAAP implications. Understand some of the considerations and complexities that could surface.
Reaction to the deduction limit
In 2017, the Tax Cuts and Jobs Act (TCJA) added a limitation to state and local tax deductions for individuals not to exceed $10,000 annually ($5,000 in the case of a married individual filing separate). The limitation is effective for tax years beginning in 2018 until 2025. In general, the limitation does not apply to state and local taxes imposed on entities — e.g., a business tax imposed on a pass-through entity that is reflected as a reduction of an individual owner’s distributive or pro-rata share of income or loss.
Certain states have responded to the state and local tax deduction limit for individual owners of pass-through entities by enacting (either elective or mandatory) a pass-through entity-level income tax. In most instances, the state also provides owners (shareholders or partners) of pass-through entities a state tax benefit in the form of a full or partial credit, deduction, or exclusion.
See our article on state-specific considerations and state-by-state effective dates
IRS Notice 2020-75 (the Notice) was issued on November 9, 2020, and states that the Treasury Department and IRS intend to issue proposed regulations in connection with a tax deduction related to amounts “… paid by a partnership or S corporation to a state, political subdivision of a state or the District of Columbia (Domestic Jurisdiction) to satisfy its liability for income taxes imposed by the Domestic Jurisdiction on the partnership or S corporation” (pass-through entity tax or “PTET”). The Notice defines these payments as “Specified Income Tax Payments,” which are deductible by pass-through entities in computing their non-separately-stated income or loss. Further, the Notice clarifies that a PTET can either be mandatory or elective and include a deduction or credit to the owners of the pass-through entity.
Objectives and scope of ASC 740
ASC 740-10-10-1 states the two main objectives related to accounting for income taxes. The first is to recognize the amount of taxes payable or refundable for the current year (current taxes payable). The second is to recognize deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns (deferred taxes).
ASC 740-10-15-2 states that “the principles and requirements of the Income Taxes Topic [ASC 740] are applicable to domestic and foreign entities in preparing financial statements in accordance with U.S. generally accepted principles (GAAP), including not-for-profit entities (NFP) with activities that are subject to income taxes.”
ASC 740-10-20 defines “taxable income” as the “excess of taxable revenues over tax deductible expenses and exemptions for the year as defined by the governmental taxing authority.” It is implied that a tax based on income includes a tax based on a measure of revenue or gains less expenses or losses and should generally be accounted for under the provisions of ASC 740 (i.e., current and deferred income tax accounting).
The entity must use judgement in determining whether a particular tax is within the scope of ASC 740, as there are taxing jurisdictions that compute tax due on a wide variety of bases that could be less than a comprehensive measure of income, but still fall within the scope of ASC 740.
Taxes paid or withheld on behalf of owners
Entities may need to consider whether a particular PTET is a transaction with the owners and should be accounted for as equity transactions pursuant to the implementation guidance contained within ASC 740-10-55-226 through 55-229. A strict reading of the language within this guidance may result in disparity between the treatment for financial reporting purposes and tax return purposes. That is, for financial reporting purposes, the PTET could be viewed as a distribution/equity transaction, and for tax return purposes, the pass-through entity could take a deduction against taxable income for state and local taxes imposed at the entity level.
On the other hand, as noted above, the Notice defines “specified income tax payments” as “… any amount paid by a [pass-through entity] to a [Domestic Jurisdiction] to satisfy [the pass-through entity’s] liability for income taxes imposed by the Domestic Jurisdiction on the [pass-through-entity]” (emphasis added). The language as written within the Notice appears to indicate that for a PTET to be deductible, the tax must be a liability of the entity and would therefore not be accounted for as equity transactions with owners in accordance with the implementation guidance.
Complexities of ASC 740 and PTETs
If it is determined that a particular taxing jurisdiction’s PTET is within the scope of ASC 740 and the tax is determined material to the financial statements, entities should consider the related current and deferred tax effects to be recognized within the financial statements. Several factors could impact the timing of recognition and measurement — including whether the PTET is required vs. elective, if elective, for what period(s) of time, and requirements for revocation of an election, among other factors of a particular tax regime.
In accordance with ASC 740-10-45-15, if the PTET is required by statute, the related tax effects should be recognized in the period that includes the enactment date. Any relevant deferred taxes should be measured at the enacted tax rates at which they are expected to reverse.
Additional complexities may arise if the PTET is an election of the entity. Certain jurisdictions permit entities to elect to be subject to a PTET for certain period(s) — typically a single annual period. The PTET is generally effectuated with the election included with or by the timely filing of the entity’s tax return, and typically does not require approval or review of the relevant taxing authority. In these instances, a question arises as to the proper timing or tax year to account for the PTET within the financial statements.
One view may be that the PTET is a change in tax status by analogy and, in accordance with ASC 740-10-25-33 and 25-34, should be accounted for when the election to be subject to a PTET for a particular jurisdiction or year is filed. This view may preclude an entity from recognizing deferred income taxes if the election is required on an annual basis (i.e., the effective date of the election does not exceed one year). Another view may be to account for the PTET election within the financial statements once management has developed and can support its intent and ability to do so in accordance with ASC 740-10-55-23. This view may also contemplate future intended elections of management with respect to the PTET.
Other complicating factors might include:
- PTET regimes that are only in effect when an entity is in a taxable income position
- Accounting for estimated tax payments made by an entity prior to the effective date of accounting for the PTET as an income tax of the entity
- Jurisdictions that compute the PTET based on the income attributable only to owners who have elected to be subject to the PTET
- Realizability of any deferred tax assets, if applicable
- Certain regimes that permit loss carryforwards or credit carryforwards that may only be realized by an entity’s current or future taxable income
- Election and revocation requirements as enacted by each taxing authority
How we can help
PTET elections can create a wide variety of complexities within financial statements. Our dedicated team of ASC 740 professionals can work closely with you to assess your facts and circumstances and further analyze the potential financial statement impacts of PTETs.