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The Secret to Saving Thousands on Your Partnership and S Corp Tax: Pass-Through Entity Election

The Secret to Saving Thousands on Your Partnership and S Corp Tax: Pass-Through Entity Election

February 16, 2023

Are you a small business owner looking to reduce your tax burden? Have you paid more than $10,000 in state tax and property tax but only got $10,000 deduction at the federal level due to SALT limit? If you answered YES to both questions, you are an ideal candidate for Pass-Through Entity (PTE) Election. For eligible entities, the most important benefit of PTE election is the ability to avoid the $10,000 SALT deduction cap. Owners of eligible entities may be able to deduct a larger portion of their state income taxes paid against federal income. This powerful tax planning strategy could save you thousands of dollars each year. And the best part is: you can still make your PTE election for 2022, which will help save your 2022 tax bill.

In this article, we'll explore the benefits of the Pass-Through Entity Election, explain how to make the election, and provide tips for maximizing your tax savings. We will also provide two examples to help you understand the PTE calculations and potential tax-saving impact.

The Tax Cuts and Jobs Act of 2017 (TCJA) introduced significant changes to the tax code, including limiting the deductibility of State and Local Taxes (SALT) for individuals to $10,000. This limit applies to all forms of state and local taxes, including income, sales, and property taxes.

To address this issue, the high-tax states have been working to establish a Pass-Through Entity (PTE) tax. In December 2020, the IRS announced in Notice 2020-75 its plans to issue regulations on the deductibility of payments by partnerships and S corporations for certain state and local income taxes. The key provisions of the notice are as follows:

  • "Specified Income Tax Payments" are deductible by partnerships and S corporations in computing their nonseparately stated income or loss.
  • The term "Specified Income Tax Payment" means "any amount paid by a [PTE] to a State, a 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 [PTE]."
  • The guidance applies to tax payments made on or after November 9, 2020, and taxpayers can rely on the notice and apply it to a PTE's tax payments made after December 31, 2017.

As a result, various states have established PTE elective taxes, which allow pass-through entities to pay a tax at the entity level instead of passing the tax liability through to individual owners. By paying the tax at the entity level, businesses could avoid the individual SALT limitation and potentially reduce their overall tax liability.

Let's examine the tax implications of making a prompt election for PTE status, using New York and California as examples.

Scenario 1: New York Partnership/S-Corp

Suppose a New York Partnership has a net income of $500,000 in 2022. To simplify the calculation, we'll use the following parameters:

  • The partner is married and files jointly
  • The partner takes the standard deduction of $25,900
  • The federal tax rate is 37%
  • The New York PTE tax rate is 6.85%

Without making a PTE election, the partnership's net income is $500,000, and the total self-employment tax is $32,728, with 50% of that amount being deductible at the individual partner's level. With the standard deduction ($25,900) and 50% of the self-employment tax deduction ($16,364), the total federal taxable income is $457,736. At the 37% tax rate, the partner's federal income tax expense is $169,362. Adding the self-employment tax, the partner would owe $202,090 for the 2022 tax return.

If the partner makes a PTE election at the 6.85% rate, the state income tax expense of $34,250 can be treated as a partnership expense and deducted for federal income tax calculation. This would bring the total federal taxable income to $465,750 instead of $500,000. This would lead to a decrease in the self-employment tax to $31,735 and the total federal income tax expenses to $188,609. As a result, the PTE election would result in a federal tax savings of $13,482.

This is a hypothetical example and is not representative of any specific situation. Your results will vary.

Scenario 2: California Partnership/S-Corp

A similar scenario applies to California, with the only difference being that the California PTE tax rate is 9.3%.

With a 9.3% California PTE election, the federal taxable income can be reduced by $46,500, which is the California income tax expense. This would result in a final federal tax saving of $18,304.

This is a hypothetical example and is not representative of any specific situation. Your results will vary.

The rules, rates, and calculations for PTEs vary between states. For instance, partners in New Jersey can make the election before March 2023 for the 2022 tax year, while in California, the election must be made and payment received by June 2022.

Making a PTE election is a crucial tax-saving strategy for partnerships and S-Corporations. If you are a business owner in New Jersey, it’s important to act promptly to take advantage of tax savings for the 2022 tax year.

Don't let regret in 2023 be your reality! For California partners, it may be too late for the 2022 tax year, but taking action now will ensure that you don't miss out on the chance to potentially lower your overall tax liability. Don't let this opportunity slip through your fingers - act now to secure a brighter financial future for your business.

Schedule a consultation with us today to learn more about the PTE election and how it can benefit your business. Our specialists will be happy to answer any questions you may have and guide you through the process.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. 

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax 

issues with a qualified tax advisor.