ASC 740 Considerations for Pass-Through Entity Tax Regimes

An increasing number of states are embracing an entity-level income tax on pass-through entities (PTEs) as a way to mitigate the $10,000 deduction limit for state and local income taxes (SALT cap). Congress imposed the SALT cap on individuals as part of the tax reform law in 2017. These PTE tax (PTET) regimes effectively bypass the SALT cap, but introduce novel considerations for companies that prepare U.S. GAAP financial statements.

Background on the PTET Workaround for the SALT Cap

Immediately after 2017, states began considering modifications to their tax laws so that new types of state taxes would not be subject to the SALT cap. In 2018, Connecticut enacted a mandatory PTET on all entities taxed as partnerships and S corporations. Other states followed suit to enact their own PTET regime; however, many of these other regimes were made elective.

By the end of 2020, the IRS recognized this emerging trend and the need for taxpayer guidance, and it officially confirmed that PTET regimes are not subject to the SALT cap. The IRS's blessing encouraged more states to introduce bills to authorize their own PTET.

So far, there are more than 20 states with a PTET. While a state’s PTET benefits business owners and investors, it creates additional complications when applying the guidance under ASC 740 Income Taxes for financial statements prepared under U.S. GAAP.

ASC 740 Accounting for Income Taxes

PTEs that issue U.S. GAAP basis financial statements must be mindful of the consequences that a state's PTET may have on the need for a tax provision. The accounting requirements are complicated by the unique nature of PTE tax regimes, which vary by state and may involve entity-level income tax liabilities levied on traditionally nontaxable PTEs.

Historically, PTEs are not subject to income tax because the tax consequences of transactions within the PTE "flow-through" to their owners. Accordingly, the entities generally do not report income tax expense or benefit, income taxes payable or receivable, and do not record deferred taxes with respect to differences between the book and tax bases of their assets and liabilities. However, an entity subject to a PTET will need to evaluate the appropriate accounting method and may now find that it is subject to income tax under the state laws governing the PTET.

Evaluating the accounting for these tax regimes should begin with determining whether it is within the scope of ASC 740, which would mean that the tax must be paid by the PTE alone, and it must be based on taxable income. This analysis can be challenging because the ASC 740 determination does not rest solely on a finding that there may be a direct imposition of tax on the PTE under a state's tax laws. 

Unfortunately, the inconsistent nature of PTE tax regimes among various states means that the PTET regime of certain states will be within the scope of ASC 740, while the regime for others will be treated as a transaction with the owners (distribution).  

The guidance in ASC 740 provides three examples (ASC 740-10-55-226 through 228) that may be helpful for this analysis. One example involves an entity that operates in a jurisdiction that “assesses an income tax on [the entity]” and allows its owners to claim a credit with respect to their pro rata share of the entity’s income tax payment. The example concludes that the owners’ ability to claim a credit against their personal income tax means that the jurisdiction’s income tax would be attributed to the owners.  The guidance then provides a contrasting example in which owners do not file tax returns and the laws do not indicate the payments are made on behalf of the owners, in which case the jurisdiction’s income tax would be attributed to the entity.

A third example discusses a scenario where the owners and the entity are jointly and severally liable for payment of income taxes, but that the laws and regulations attribute the income tax to the owners regardless of who pays the tax. In that scenario, it concludes the income tax payment by the entity is treated as a transaction with the owner.

Each state’s PTET regime is unique and may provide different elections for the PTEs participating in the programs, so an assessment of all of the facts and circumstances related to each program an entity participates in may be necessary. Comparison of the similarity and differences between each state’s PTET regime and the elections the entity makes under those programs to the three examples above will often be helpful in concluding whether a PTET regime should be accounted for as an income tax or as a transaction with an owner.

Timing of Recognition

Another question to consider in accounting for a PTET is the timing of recognition. If a jurisdiction’s PTET is within the scope of ASC 740, then accounting for the effects of the election would occur when the election has been filed with the taxing authority. So, if a company makes an election in a filing with the taxing authority before the end of the year, it would account for the PTET under ASC 740 during the current period. However, an election filed with the taxing authority after the end of the year that is retroactive to the prior year for tax purposes is not reflected in the current year's financial statements. Instead, this election should be reported as a subsequent event. This treatment would not be impacted by a board resolution or other actions the company takes before year-end.

Alternatively, if a jurisdiction’s PTET is accounted for as an equity distribution, the timing of recognition is based upon the company's commitment to its owners. Therefore, if a company has passed a board resolution to participate in a PTET regime before the end of the year, the entity may have in substance declared distribution and should accrue the distribution as of that date. The subsequent filing of the tax election after the end of the year does not affect when a distribution is accrued.

Lack of Uniformity for Election Timing and Mechanics

There is a lack of uniformity among states with PTET regimes. Significant differences include the following:

• Eligibility: Some states allow all PTEs to elect into their entity-level tax regime, whereas others do not permit partnerships with corporate or higher-tier partnerships to elect into an entity-level tax regime.
• Election Due Date: Most states require the entity to make an affirmative election into an entity-level tax regime by March 15 or April 15. In some states, the election is permanent, while others require an annual election. Some states permit the decision to be deferred until a time that is after the return's original due date. New York, Oklahoma, Michigan, and other states require PTEs to elect in to their entity-level tax regime before the end of the tax year covered by the election.
• Credit vs. Exclusion: In many states, the tax paid by the PTE passes through to its owners, who then claim it as a credit against their personal income tax liabilities in the same states. However, in other states, the owners do not report the income from the PTE or receive a credit for PTE taxes paid, and instead are directed to exclude their allocable share of the PTE's income from their personal taxable income.
• Tax Base: Many states tax 100% of a PTE's income allocable to resident owners, and only the state-sourced income allocable to non-resident owners. Other states only tax the PTE's state-sourced income, regardless of the owner's residency. And some states tax the PTE's income allocable corporate partners and higher-tier partnerships, whereas other states tax the PTE's income allocable only to individuals.

Final Thoughts

Many variables and potential complications of a PTET election require thorough research and consideration. A tax professional can work with you to analyze your unique situation and assist with the tax savings process. An accounting professional can help you understand the interplay with ASC 740. If you have any questions about PTET elections or want to discuss further options, please contact us.