Year-end 2021 Pass-Through Entity Tax Deduction Opportunities

Year-end 2021 Pass-Through Entity Tax Deduction Opportunities

Michigan and Illinois have recently joined a number of other states with their enactment of new laws providing an opportunity for owners of a pass-through entity (“PTE”) such as tax partnerships and S corporations to achieve federal income tax savings with respect to the PTE’s taxable income. However, steps may need to be taken before year-end to achieve these tax savings in 2021.

SALT Cap and SALT Cap Work-Arounds

In 2017, the Tax Cuts and Jobs Act (“TCJA”) capped the amount of the itemized deduction of individual taxpayers and certain trusts and estates for state and local taxes at $10,000 (the “SALT Cap”). Among the taxpayers particularly affected by this limitation have been individual/trust and estate owners of PTEs who pay significant personal state income taxes on the PTE’s taxable income. In the wake of the TCJA, states began passing new legislation imposing state income taxes on the PTE rather than its owners. These PTE-level taxes are intended to provide a federal income tax deduction for the state income taxes without limitation at the individual /trust and estate taxpayer level under the SALT Cap (“SALT Cap work-arounds”). The Internal Revenue Service subsequently issued favorable guidance in November 2020 establishing that SALT Cap work-arounds meeting specified requirements permit a deduction of state income taxes at the PTE level regardless of whether the taxes are imposed on the PTE directly or pursuant to an election under the applicable SALT Cap work-around. 

Michigan and Illinois SALT Cap Work-Arounds 

Most recently, on December 20, 2021, Michigan’s Governor Whitmer signed legislation enacting a new SALT Cap work-around allowing Michigan taxpayers to elect into a PTE income tax regime. The electing PTE would be subject to a 4.25% tax and the owners of the PTE would be entitled to an income tax credit for their share of the taxes not limited by the SALT cap.  Similar legislation was signed in Illinois by Governor Pritzker.  Both statutes are first applicable to the 2021 tax year.  The enactment of Michigan’s and Illinois’s SALT Cap work-arounds have expanded the opportunities for owners of PTEs filing tax returns in those states to take advantage of new SALT Cap work-arounds. However, PTEs need to be mindful of timing-related considerations relevant to ensuring the deduction of those taxes in 2021.

Timing Considerations for SALT Cap Work-Arounds

PTEs that desire to deduct Michigan or Illinois PTE taxes in 2021 need to consider the relevant state procedures for making the PTE election and paying the PTE taxes. This is because the federal income tax deduction of state taxes is subject to a variety of limitations that differ depending upon the taxpayer’s method of accounting (i.e., cash method or accrual method).

For cash method taxpayers seeking a 2021 deduction for PTE taxes the PTE’s taxes should be paid on or before December 31, 2021.

For accrual method taxpayers, a conservative approach to provide the strongest tax reporting position for a 2021 tax deduction would be to make the payment on or before December 31, 2021. The determination of whether an accrual method taxpayer, including one that makes a payment in 2021, would be eligible for a 2021 tax deduction is based upon an application of the accrual method tax accounting rules as applied to the PTE’s particular facts and circumstances, but it seems clear that the prudent course of action would be to pay the tax before the end of 2021 if possible.

Members of Honigman’s tax practice group are available to advise on the PTE laws in these states and others.  Please reach out to your Honigman tax, corporate or other contact and/or to your tax accounting advisors for counsel and advice on these matters.

States that have enacted PTE legislation have been slow to release, and in many instance have not released, guidance.  The lack of guidance creates uncertainties that almost certainly will not be clarified before year end.