House Bill Limits Benefit of State PTET Deduction

Early on May 22, the House passed its budget reconciliation bill, which includes some changes to the tax language approved by the Ways and Means Committee on May 14, including an increase in the limit on the deduction of state and local taxes (SALT cap). However, the House did not change the new limit on the deductibility of state pass-through entity taxes for certain types of businesses.

Crowe observation

If enacted, the provision would significantly limit the PTET deduction benefit for owners of pass-through entities in professional service sectors such as healthcare, legal, accounting, financial services, brokerage services, investing, and consulting.

Background

Under the Tax Cuts and Jobs Act of 2017 (TCJA), for the 2018 to 2025 tax years, individual taxpayers generally are limited to a $10,000 federal tax deduction for personal state and local taxes (the SALT cap). Residents of states with a high tax burden are most negatively affected by the SALT cap.

Many states enacted workarounds to mitigate the effects of the SALT cap. One of these workarounds is the elective PTET regime to ease the state tax burden that otherwise would flow through to owners of pass-through entities. The PTET regime allows partnerships and S Corporations to pay state income taxes at the entity level. Such taxes are reflected in a partner’s or S Corporation shareholder’s distributive pro rata share of income or loss and the owners get a state tax credit for the amount of tax paid by the pass-through entity.

The IRS published Notice 2020-75 to announce its intention to issue regulations allowing partnerships and S Corporations to deduct state and local tax payments in computing nonseparately stated income or loss. In response, many states enacted PTET regimes.

The Joint Committee on Taxation’s explanation of the Ways and Means Committee version of the reconciliation bill states that, “Notice 2020-75 provided authority for certain passthrough entity owners to partially avoid the temporary Federal limitation on individual tax deductions by converting a personal income tax liability (potentially nondeductible for such owners) into an entity-level tax liability (putatively deductible for the entity in computing non-separately stated income).”

TCJA also enacted a 20% pass-through deduction under Section 199A. The deduction phases out above certain income thresholds for owners of a specified service trade or business (SSTB). Under Section 199A, an SSTB is a trade or business that involves the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. An SSTB also is a trade or business that consists of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

House Reconciliation bill

The House reconciliation bill makes Section 199A permanent, raises the deduction to 23%, and revises the rules for owners of SSTBs that meet new, higher income thresholds. The language in the bill also would increase the SALT cap in 2025 to $40,000, though the ability to deduct state and local taxes is phased out at $500,000.

The good news regarding Section 199A and the SALT cap is tempered, however, by changes that would limit state workarounds of the SALT cap, including limiting the benefit of PTET for owners of SSTBs.

Looking ahead

As the latest actions by the House demonstrate, the budget reconciliation process continues to be dominated by negotiations aimed at balancing cutting the deficit with meeting the divergent tax policy goals of the Republican majority in Congress. The fate of any particular provision in the tax portion of the bill, including the SALT cap, Section 199A, and limits on the PTET, will remain uncertain until the Senate completes it work on the reconciliation bill.