Guest contributor, MCFE member, and former Minnesota House of Representatives legislative analyst Joel Michael examines the design, implications, and tax policy issues of the bill allowing pass through business entities to elect to pay state income tax at the entity level and thereby circumvent the federal government’s $10,000 cap on state and local tax deductibility.
The Tax Cuts and Jobs Act or TCJA, the $1.5 trillion federal tax cut, presented high tax states, like Minnesota, with two challenges:
The ink from signing TCJA was barely dry before high tax states began searching for workarounds to the SALT cap and its resulting tax price increase. The first effort, converting income and/or property taxes to charitable contribution deductions which remain uncapped under TCJA, was blocked by the IRS, reducing it to a legal challenge with little probability of success. A second approach gives pass through entities (PTEs) like S corporations and partnerships the option of paying state income tax at the entity level, thereby making the tax deductible. Whether that approach “worked” was uncertain. But in a November announcement, which immediately captured the attention of business owners, tax practitioners, and government officials in “blue states” across the nation, the IRS blessed that approach.[1]
The IRS decision all but ensures that states with income taxes will enact PTE elective entity taxes. Failure to do so would forgo a large helping of federal tax savings for owners of in-state PTEs at no state budget cost. The potential federal tax savings are large. If half of PTEs with top tax bracket owners participate, federal tax savings to owners of Minnesota PTEs could be more than $150 million annually. The amounts make it more a matter of when and how, rather than whether to enact a PTE entity tax option. But PTE entity taxes can be structured in different ways and enacting one has tax policy implications.
PTEs as entities are exempt from income taxation. Instead, they “distribute” or report their income and other tax attributes to their owners who pay any resulting tax on their individual tax returns. State and local income taxes are reported separately and are allowed to the owners as itemized deductions. Put another way, state income taxes are not treated as business expenses that reduce the PTE’s reported income, but are subject to itemized deduction rules, including TCJA’s cap on SALT deductions.[2] But longstanding IRS guidance allows state income taxes imposed on the entity itself to reduce the income distributed to the owner, treating them like a deductible expense, thereby avoiding the itemized deduction rules. That presents a SALT cap workaround possibility with two conceptually simple elements:
Seven states have enacted PTE entity tax workarounds to the SALT cap as shown in the table. The table’s last row shows how the Minnesota bill, S.F. No. 263, compares.
State |
Citation |
Limited to tax entities* |
Elective |
Entity tax rate |
Top state PIT rate |
Top state corporate rate |
Entity tax base |
Coordination with individual tax |
Connecticut |
Yes |
No |
6.99% |
6.99% |
7.5% |
PTE distributions |
Credit limited to 87.5% of entity tax |
|
Louisiana |
Yes |
Yes, by owners of > 50% of capital |
Graduated with top rate of 6% |
6% |
8% |
C corp rules |
Exclude income |
|
Maryland |
No |
Yes, annual |
Top state rate plus lowest county rate |
5.75% (state) plus county rates |
8.25% |
PTE distributions |
Credit; nonresident PTE owners do not qualify – entity tax is withholding tax |
|
New Jersey |
Yes |
Yes, by consent of all owners |
Graduated; top rate of 10.75% |
10.75% |
9% |
PTE distributions |
Refundable credit. |
|
Oklahoma |
Yes |
Yes until revoked |
5% (individuals) 6% (corporate) |
5% |
6% |
PTE distributions |
Exclude income |
|
Rhode Island |
No |
Yes, annual |
5.99% |
5.99% |
7% |
PTE distributions |
Credit |
|
Wisconsin |
Yes |
Yes, annual by majority of owners |
7.9% |
7.65% |
7.9% |
C corp rules |
Exclude income |
|
Minnesota bill |
S.F. 263; H.F. 501 |
No |
Yes by owners of majority interest |
9.85% |
9.85% |
9.8% |
C corp rules |
Exclude income |
*Entities qualifying under federal law as S corporations or as tax partnerships |
Under the IRS announcement and as a practical matter, the earliest the legislature could provide a PTE option is for tax year 2021. The proposed regulations are unlikely to be published before the end of the regular session. So, some uncertainty will remain as to exactly what they require. If the primary goal were to simplify crafting legislation meeting the IRS requirements, it may make sense to wait. But given the federal tax savings at stake, I expect the 2021 legislature to enact a PTE entity option, effective for tax year 2021. If the IRS regulations require changes, the 2022 legislature can do so.
That leaves the question of how to formulate the PTE entity tax beyond the obvious basics of satisfying both the IRS regulations and constitutional requirements. Since details of the IRS regulations remain uncertain, that likely counsels adopting a narrower law that can be expanded later.
Constitutional considerations dictate that an entity option apply only to the PTE’s Minnesota source income. By contrast, the individual income tax on residents with PTE income applies to all their PTE income, including from sources outside Minnesota. Residents are allowed a credit for tax they pay to another state on that income to avoid double taxation. To prevent a state revenue loss, this non-Minnesota source income needs to remain taxable under the individual income tax when received by residents. Whether that tax becomes deductible will depend on the other state enacting a PTE entity tax.
The features of other states PTE taxes in the table suggest at least four design issues or alternatives:
Mandatory or elective -- This is the easiest of the issues to resolve. An entity level tax can disadvantage some PTE owners (e.g., if they are using the PTE losses to reduce other income or other losses to reduce the PTE’s income), creating winners and losers. Since a mandatory tax is unnecessary to satisfy the IRS, an elective tax seems a given politically to minimize losers. A mandatory tax makes sense mainly if a goal is to raise revenue, rather than to score federal tax savings for owners of PTEs subject to Minnesota tax. All states, except Connecticut, have enacted optional taxes.
Qualifying entities -- There are two main questions regarding which entities should qualify:
Tax base, rate, and calculations -- Most states use the deemed income tax distributions of PTE in-state source income as the entity tax base. That mirrors PTEs’ existing tax reporting; they would simply sum the distributions of in-state source income reported for purposes of federal tax law, apply the relevant tax rate(s) and pay the tax. Louisiana, Wisconsin, and the Minnesota bill instead apply their C corporate taxes as the entity tax. In Minnesota that will result in slight differences in the tax base and require the entity to go through an additional step of applying state corporate tax rules to determine its tax. It may have a modest constitutional advantage by mirroring the time-tested state corporate tax model and treating PTEs the same as C corporations.
Most states and the Minnesota bill use the top individual income tax rate as the PTE entity tax rate. Other states apply their graduated individual rates or the rate under the corporate tax (Wisconsin). The choice of a rate obviously is one key to determining the effect of the option on both state revenues and participation by taxpayers.
Coordination with the individual income tax --To prevent PTE income from being taxed again at the individual level (recall it is included in AGI, the starting point for the Minnesota individual income tax), owners can either be allowed to claim their share of the PTE entity tax as a credit against their state liability or they can exclude the PTE’s in-state income in calculating their state income tax. Four of the existing PTE entity taxes use the former method. The Minnesota bill and three states the latter. The credit more accurately compensates the taxpayer, while the income exclusion approach may yield slightly higher state revenues. That is so because the income exclusion could reduce tax paid personally by the taxpayer at rates lower than the top bracket. That, of course, assumes that the rate selected is the top individual income tax rate, as the Minnesota bill provides.
Other states’ enactment of PTE entity taxes effectively means Minnesota should modify its credit for taxes paid to other states, even if it does not enact a PTE entity tax option, to satisfy constitutional requirements. The credit prevents Minnesota residents who derive income from other states, including because they own a PTE with operations in another state, from paying tax twice on the same income. Like all states, Minnesota taxes its residents on all their income and provides a credit for taxes paid on that income to other states.[3] Minnesota’s credit applies to entity taxes paid by S corporations, but not partnerships.[4] Prior to SALT cap workarounds, states rarely, if ever, taxed partnerships as entities. But with enactment of PTE entity taxes, the Minnesota credit should be extended to partnerships paying PTE entity taxes to prevent double taxation of that income. The Minnesota bill does that only for partnerships electing the Minnesota entity tax; it should be extended to all partnerships if they pay entity taxes in another state. [5]
Revenue neutrality is not an essential feature of an optional PTE entity tax proposal. One could be constructed either as a tax increase, clawing back some of the federal tax savings it confers, or as a tax reduction, lowering PTE business taxes beyond the federal savings. Revenue neutrality will make a proposal a better candidate for legislative approval by avoiding political objections to tax increases or cuts and the state budget crossfire.
Revenue neutrality can be achieved by setting the tax rate at the appropriate level to hold state tax revenues constant. The challenge, of course, is determining what that rate should be. I do not have access to the data necessary to estimate and am not a revenue estimator, in any case. Even with access to data, the task is not easy. DOR Research so far has punted, scoring the effect as “unknown.”[6]
It is useful to note some of the moving parts that affect the estimate:
The benefit of an election for an individual owner of a PTE will vary based on their federal and Minnesota marginal tax rates. For a PTE owner to benefit from an election, the federal tax savings (a function of the federal marginal rate) must exceed any higher tax from the flat tax rate. An election could reduce some of a PTE’s owners net taxes, while increasing them for others. S.F. No. 263, as introduced, authorizes owners of a majority of the PTE “ownership interests” (I presume that refers to capital, not income or profits, interests) to make the election. How PTEs will act when their owners have conflicting interests is uncertain. Some may be reluctant to raise the taxes on minority owners or may feel obligated to make compensating adjustments holding owners who would pay more harmless.
Taxpayers with income from a PTE below the top Minnesota rate bracket are unlikely to make the election because the federal tax savings would be insufficient. However, that may not be true if other (non-PTE) income puts enough owners in the top federal tax bracket. To state the obvious, elections are likely to be most beneficial to top-bracket taxpayers and those with the most tax on PTE income. For top bracket taxpayers, the federal tax savings should make an election attractive financially.
The complexity and uncertainty estimating the potential revenue effects are apparent. Accurately estimating the effect requires modeling PTE behavior, a function of their owners’ personal tax situations, and then, linking that back to the owners’ tax returns. The state’s models (at least based when I was working a few years ago) are not well designed to do that, nor do the tax return samples have all the necessary data. Beyond the lack of necessary data and modelling capacity is the inherent challenge of making assumptions about owner behavior. DOR’s initial score of “unknown” is understandable.
My intuition is that a large share of PTEs whose owners are in the top two federal tax brackets will make the election if Minnesota enacts S.F. No. 263 or a similar bill and that it will slightly increase state revenue or, at least, not reduce them. But that is simply a guess on my part. Experience in the other states whose laws applied in tax year 2019 may help guide DOR in estimating the potential effects.
Although I believe enactment of PTE entity tax option is all but inevitable, it is worth reflecting on some of its basic tax policy implications:
Unless the federal SALT deduction rules change, it seems inevitable that a PTE entity tax election law will be enacted. If not in 2021, then in a future legislative session. The federal tax savings are simply too compelling for a high tax state like Minnesota to pass on. That is particularly true, since legislators persistently raise concerns about business owners leaving the state and/or the challenges that Minnesota high income tax creates for attracting business investment. The legislature passing on “free” federal tax benefits that would reduce the state income tax by a third or more for some of the state’s highest earners or potential investors seems unthinkable. States have a long history of changing their tax and nontax laws to enable their residents to capture federal tax savings for better or worse.[9] The resulting distortions of state tax policy illustrates the potentially unintended effects that can be triggered by federal tax changes, like TCJA’s SALT deduction cap.
[1] Notice 2020-75, 2020-49 IRB 1453 (Nov. 9, 2020) (announcing the plan to issue proposed regulations allowing optional PTE entity income taxes to reduce distributed PTE income).
[2] PTE owners like to claim they pay their business taxes on their individual returns. That is partially true if the income is retained by the entity as working capital. But it is also the case that those taxes are their individual income taxes, comparable to taxes paid by workers and investors on wages, interest, and dividends. Federal and state law resolves this ambiguity by subjecting them to the same rules that apply to wage earners and passive investors’ taxes – that is, they are deductible only as itemized deductions.
[3] It is not clear that a credit for taxes paid to other states is constitutionally required. But a credit is one path to satisfy constitutional requirements and if that is the path taken, it almost certainly must be fully effective.
[4] Minn. Stat. § 290.06, subd. 22(g). White v. Comm’r of Revenue, Docket No. 6558 (MN Tax Court, Aug. 18, 1995), confirmed that this rule applied when a state imposed both individual and entity taxes.
[5] For an explanation of the constitutional rationale see Walter Hellerstein and Andrew Appelby, “State Tax Credit Issues Raised by SALT Cap Workaround Legislation,” Tax Notes State, January 14, 2021.
[6] DOR, Analysis of S.F. No. 263 (Bakk), As proposed to be amended (January 25, 2021).
[7] Steven N.J. Wlodychak, “IRS Just Raised State Taxes for Multistate Passthrough Entity Owners,” Tax Notes State, vol. 98, pp. 1159-65 (Dec. 14, 2020) describes this issue, as well as Hellerstein and Appleby article cited in note 5.
[8] For example, the Tax Foundation suggests states should be cautious about enacting PTE entity taxes on that basis. Moreover, it would compound TCJA’s favoritism for taxpayers with business income. With one hand TCJA conferred on many PTE owners the much criticized 20-percent deduction for qualified business income, while with the other suspended employees’ ability to deduct their business expenses.
[9] States’ adoption of community property laws to qualify for income splitting for married couples under the Supreme Court’s 1930 decision in Poe v. Seaborn provides a striking example. Even though adopting community property rules made material changes in substantive spousal property law, state began change their laws to qualify for the federal tax benefits under Poe’s income splitting rule. When that appeared poised to become a trend after WWII, Congress responded by allowing income splitting without regard to state property law. In response, most states that had enacted them repealed their community property laws. See Stephanie Hunter McMahon, To Save State Residents: States' Use of Community Property for Federal Tax Reduction,1939-1947, Law & History Review, vol. 27, pp. 587 - 628 (2009) for an account. Professor McMahon observes, “Although it was not guaranteed that states' adoption of community property statutes would yield the same tax benefit as in Poe v. Seaborn, wealthy residents' ability to vote with their feet forced states to try as competition for taxpaying residents produced a race between states to lower federal income taxes.” Ibid. 588.