The Entity-Level Election Could Help Lower Your Tax Bill
- The entity-level election allows pass-through entities to be taxed at the entity level and bypass the SALT deduction limits.
- Choosing to use the entity-level election may be a valuable tax strategy.
- The state and local tax deduction limit may be repealed in the near future.
Want to know if the entity-level election would benefit you?
The state and local tax (SALT) deduction has generated a lot of buzz the last few years and has recently become a hot topic in the tax world. Back in 2017, the Tax Cuts and Jobs Act (TCJA) limited the deductible amount of state and local income, real estate, and other taxes to $10,000 (for those individuals that itemize on their individual returns). Like with most new tax rules, taxpayers have been looking for a workaround to help lower their tax bills.
Shortly after the TCJA was enacted, Wisconsin introduced the entity-level election. This allowed pass-through entities (PTE) to be taxed at the entity level, and deduct their tax payments at the federal level, thus essentially bypassing the $10,000 SALT deduction limits. This was especially beneficial to PTE owners who had already reached the $10,000 limit or were taking the standard deduction on their individual return.
This was a relatively a new concept in the tax world, so practitioners and states weren’t sure how the IRS would view these elections. In late 2020, the IRS finally issued guidance that approved these transactions and paved the way for states to enact SALT cap workarounds.
Over the past couple years, states like Alabama, Arizona, Arkansas, Connecticut, Georgia, Idaho, Louisiana, Maryland, New York, New Jersey, Oklahoma, Rhode Island, and South Carolina have followed Wisconsin and approved SALT cap workarounds. Additionally, many other states have introduced SALT cap workaround legislation.
Applying the SALT cap workaround
So how do these entity-level elections or SALT cap workarounds actually work? Historically, a nonresident in a PTE would either:
- File a composite return and pay tax at the entity level (and not file an individual nonresident return in the state), or
- File a nonresident individual return in the state and pay tax at the individual level. This tax is currently subject to the $10,000 SALT deduction limit.
If the nonresident taxpayer instead chooses to make an entity-level election, the tax would be paid by the PTE and treated as a state corporation tax versus a shareholder/partner tax. That tax would then be deducted on the PTE’s federal return, and thus reduce the ordinary taxable income on the nonresident’s K-1. The nonresident would no longer be required to file a nonresident return individually. Most states will still allow a credit for taxes paid to another state for the entity-level tax as the tax is based on net income.
Let’s look at an example as to how this could be a beneficial tax strategy.
ABC Trucking Company (ABC), an S corporation, has one owner (Mary), who is a Minnesota resident. ABC reports taxable income of $2 million on its federal S corporation income tax return (Form 1120S).
ABC has a 15% apportionment in Wisconsin, and the company has no state tax differences between its federal and Wisconsin returns. Thus, ABC has Wisconsin-sourced income of $300,000. Meanwhile, Mary has reached the $10,000 SALT deduction limit on her personal return with real estate taxes and income tax paid to Minnesota prior to any tax paid to Wisconsin.
Without entity-level election
If Mary chooses not to use the entity-level election, she would need to file a composite return (through ABC) or file a nonresident individual return in Wisconsin. With a top tax rate of 7.65% (ignoring the graduated rate schedule), Mary would pay $22,950 ($300,000 x 7.65%) in tax to Wisconsin. Since Mary has already reached the $10,000 SALT deduction limits, she wouldn’t get a tax deduction for the tax paid to Wisconsin. Mary would also claim a $22,950 credit for taxes paid to another state on her Minnesota resident return.
With entity-level election
Using the entity-level election, ABC would pay tax at 7.9%, totaling $23,700 ($300,000 x 7.9%) to Wisconsin. This results in ABC and Mary paying an additional $750 of tax to Wisconsin.
However, since ABC is an accrual basis taxpayer, ABC would get to deduct the $23,700 of tax paid to Wisconsin and reduce its federal taxable income to $1,976,300 ($2,000,000 – $23,700). This results in Mary saving $7,015 in federal tax ($2,000,000 x 29.6% = $592,000, compared to $1,976,300 x 29.6% = $584,985). Mary would also claim a $23,700 credit for taxes paid to another state on her Minnesota resident return.
So even though ABC and Mary paid an additional $750 to Wisconsin after making an entity level election, Mary ended up saving $7,015 on her personal return. This resulted in Mary saving $6,265 in total tax.
Repeal or no repeal
Many expected the Biden administration to repeal the $10,000 SALT cap limitation soon after taking office, but it seems they are focusing on other priorities. A repeal was left out of both of the administration’s recent proposals (The American Families Plan and the American Jobs Plan). However, representatives and senators from some higher tax states have indicated they won’t vote for a proposal without a SALT cap repeal. The administration has indicated it is open to including a repeal, but it would need to be paid for by tax increases.
There is a chance the SALT deduction limit could be repealed in 2022 (it is unlikely that a change would be made retroactive for the 2021 tax year). With that said, another valuable tax strategy to consider is to pay your fourth-quarter state tax estimates in January 2022 instead of in 2021. This could give you the benefit of a tax deduction on your individual returns if the SALT deduction limit gets repealed in the upcoming months. The SALT deduction limit is scheduled to expire at the end of 2025 under existing law.
How we can help
Consider your personal tax situation before implementing these strategies. While making an entity-level election in our current environment may be beneficial, work with your tax advisor to do a complete analysis. Our state and local tax professionals can answer your questions to help you take advantage of these potential tax saving opportunities.