The 2017 tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA) caught states off-guard. The speed at which the federal legislation moved did not allow much time for states to react before the calendar year 2017 ended and the 2018 calendar year began, particularly for states that follow a “fixed date conformity” to the Internal Revenue Code (IRC). Even states that follow "rolling conformity” may have been forced to follow the change to the IRC, unless they already de-coupled from certain IRC provisions.

The significance of how tax reform provisions within the TCJA affected states continues to play out as states legislate different outcomes. New York is the latest to make a tax change for pass-through entities to effectively allow its partners to avoid the limitation for state taxes paid. Taking a closer look at New York’s tax change could reveal what other states may do for pass-through entity taxation. Private equity (PE) and venture capital (VC) firms should take note, as this could affect some of their filing obligations and outcomes.

Setting the Stage

Between 2017 and 2021, more information has become available for states to adjudicate the impact of the federal TCJA changes on their resident/non-resident taxpayers. One of the most hotly debated provisions has been whether the “SALT Cap” under IRC Section 164 (limiting the federal SALT deduction) is fair/constitutional, and whether it has the legislative longevity to make any state legislative change necessary.

States with high local taxes like New York, New Jersey, and Connecticut argued that the law was “unconstitutional” and hoped the Supreme Court would overturn it given its “unfair”/inequitable” impact on US taxpayers, wherever located.

Unlike the states of New York and New Jersey which opted to wait for the Supreme Court before making changes to state tax laws, the state of Connecticut decided to legislate a state “insurance policy” in the event the Supreme Court case did not ultimately decide in the states’ favor. This “insurance policy”, signed into Law on May 31, 2018, was a somewhat unique, mandatory tax, imposed on pass-through entities (PTEs). The Connecticut law gave most taxpayers some relief from federal tax. However, Connecticut decided to keep 7% of the “benefit” for itself by only giving taxpayers a 93% tax credit, for taxes paid by the PTE, which would otherwise be equal to the tax due on its distributive share of PTE earnings for tax years beginning on or after Jan. 1, 2018. Since enacting the law, Connecticut decided to increase the amount of revenue it could get from the TCJA-related federal tax change, and reduced the state tax credit for taxes paid by the PTE to 87.5% for tax years beginning on or after Jan. 1, 2019.

Other States Respond

States have started to slowly follow the example set forth by Connecticut, although none of the states made the elections “mandatory,” nor apply a haircut the same way Connecticut did. However, once the IRS came out with IRS Notice 2020-75, blessing the PTE tax as a valid workaround solution to the “SALT Cap,” and it became apparent that President Biden would not be able to sway Congress to repeal the provision in a bi-partisan way, there has been a proliferation of states, including New Jersey and now New York, that have enacted PTE taxes.

States have decided to generally apply one of two strategies to counterbalance the impact of the federal SALT cap on their respective state income taxes imposed:

  • Income Exclusion, where the PTE tax reduces owners’ distributive share of income in that state and non-resident owners have no filing obligation; or
  • Tax Credit, where partners/members receive distributive share of PTE’s income and tax paid as a personal income tax credit in that state. Non-resident partners/members must file an in-state return in order to claim credit.

State Tax Impact on Individual Partners/Members/Owners

All “residents” are taxed on 100% of their income from everywhere. However, residents may be able to claim a credit against their resident state tax returns for taxes paid to non-resident states. Often this credit is called “other state tax credit” (OSTC), which is equal to the lesser of:

  • Income tax paid to the non-resident (“other”) state(s), or
  • Tax otherwise imposed by the resident state (in order to avoid any rate arbitrage).

Note, composite and withholding taxes are imposed on individual owners, and paid on behalf of the owners by the PTE.  

Most “non-residents” (or residents that don’t have a “domicile in the state”) are only taxed on income earned in the non-resident state(s) (employment, investments, etc.). They cannot claim an OSTC, as this income presumably is appropriately sourced/taxed to this jurisdiction.

Individual Reporting of PTE Taxes

For individual owners, partners, and/or members, the individual reporting requirements will depend on whether their resident state falls into the Income Exclusion or Tax Credit treatment for its PTE tax. Note that in addition to the states below, there are pending proposals in California, Colorado, Illinois, Massachusetts, and Minnesota related to this treatment.

Income Exclusion States

Resident partners/members of PTEs that make this election in other “income exclusion” states may not be taxed on their PTE income earned in that non-resident state. Non-resident owners of PTEs in these states where the PTE makes the “income exclusion” election may no longer be taxed (if they don’t otherwise have income sourced to this state, or obligation to file). Please note: Since residents must pay tax on 100% of their income, excess tax will be paid if the resident state does not allow a credit for taxes paid to a non-resident state, either because:

  • Owner income taxes paid do not qualify, or
  • Taxes paid at the PTE level do not qualify

For the latter, a return must be filed in the non-resident state in order to claim the credit.

Current Listing of Income Exclusion States

As of the publication date, the following are states offering “income exclusion” (effective dates are in parentheses):

  • Alabama (2021)
  • Arkansas (2022)
  • Georgia (2022)
  • Louisiana (2019)
  • Oklahoma (2019)
  • South Carolina (2021)

Tax Credit States

Non-residents owners of PTEs that make this election may not be taxed on their PTE income earned in that non-resident state, by applying the “tax credit” in that state. Please note, a resident owner of a PTE that makes this election in a non-resident state may be permitted to take the OSTC “paid” to these non-resident states. If income earned is subject to tax in non-resident states, even though this tax is not paid by the taxpayer (due to the PTE tax credit – paid by the PTE), a resident may not have a non-resident tax (paid by that individual) to compare; as such, the OSTC offset may be “zero” and/or otherwise not applicable.

Current Listing of Tax Credit States

  • Connecticut (2018)
  • Idaho (2021)
  • Maryland (2020)
  • New Jersey (2020)
  • New York (2021)
  • Rhode Island (2019)
  • Wisconsin (2019)

Bottom-Line for PE/VC Companies

Partners/members/owners in PTEs that are resident in high-tax jurisdictions will likely benefit from the PTE tax changes. However, residents in low-tax jurisdictions and certain non-resident taxpayers may not benefit, especially if the state(s) have limitations on OSTCs available on taxes not directly “paid by the taxpayer,” and not tax indirectly “paid by the PTE.” In addition, care needs to be given to the types of income earned in the state to determine if the PTE tax is an applicable choice.

As such, modeling is strongly encouraged to evaluate the whole situation properly before making a PTE tax election. Although most of these PTE taxes are annually elective, a few states are making these elections binding until formally revoked. Therefore, forecasting may be needed if one believes that the future of the PTE may change over time. Lastly, states may follow Connecticut’s example to either make the election:

  • Mandatory (no longer elective), and
  • Limit the amount of credit available (e.g., only 87.5% in Connecticut currently, and only 90% proposed in Massachusetts currently).

Lastly, there are different rules about who can/cannot make a PTE tax election, given certain ownership/management restrictions of which partners/members/owners of PTEs will want to be aware.

For More information

To learn more about how these developments affect your organization, please contact us.

Published on June 22, 2021