Taxes – they’re about as enjoyable as a trip to the dentist, right? But what if I told you there’s a clever loophole that can help you legally dodge the dreaded $10,000 annual cap on state and local taxes (SALT)? Enter PTET – the State Pass-Through Entity Tax, your ticket to cutting through the tax clutter.
Understanding the SALT Tax
Before we dive into the wizardry of PTET, let’s demystify the SALT tax. For those who itemize deductions, it’s possible to deduct certain state and local taxes from your tax bill. However, thanks to the Tax Cuts and Jobs Act (TCJA) of 2018, this deduction was capped at a measly $10,000 per year. This cap covers various taxes like state real property taxes, state income or sales taxes, and personal property taxes. The catch? This cap is set to stick around until 2025 unless Congress decides to make it a permanent fixture.
The SALT cap doesn’t just leave taxpayers groaning; local governments are estimated to be missing out on a whopping $24.4 billion due to this limit. But fear not, PTET is here to help.
Meet PTET: The Heroic Tax Bypass
Picture this: you’re a business owner, and you’re churning out profits through your partnership, limited partnership, S-corporation, or multi-member LLC. You’re watching your tax bill grow, inching closer to that $10K SALT cap. But wait, there’s a plot twist – PTET.
Pass-Through Entity Taxes work like this: instead of you paying those state income taxes from your personal tax return, your business entity (PTE) swoops in and covers the bill. This isn’t just a charitable move; the PTE then nabs a federal business expense deduction for those state income tax payments. And the cherry on top? This deduction isn’t subject to the $10K SALT cap. Neat, right?
PTET in Action: An Enchanting Example
Let’s step into the shoes of ABC, LLC, a two-member LLC raking in $400K in net income. Both members are grappling with hefty California property taxes exceeding $10K. What’s their play?
Option 1: No PTE Tax
They let the $200K each pass through and each pays 9.3% CA income tax, chalking up $18,600 each. But here’s the bummer – this isn’t deductible on their federal income tax returns because of the SALT cap from property tax. If their federal tax rate is 24%, they’re looking at a total of $48K.
Option 2: The PTET Magic
Now, if both LLC members hop on the PTET bandwagon, the LLC forks over a 9.3% PTE tax to the California Franchise, amounting to $37,200 of the $400K net income. This payment turns into a deductible federal business expense, lowering the net income to $362,800. Each member reports $181,400 on their individual Federal K1’s, leading to a tax bill of $43,536 (at a 24% federal tax rate).
But wait, there’s more! On their California income tax returns, they each report $200K of net income from ABC partnership LLC, adding the $18,600 share of PTE tax paid by the partnership. They take a tax credit of $18,600 against their individual California income tax, effectively eliminating the need for extra CA income tax payment.
Bye-bye $4,464 in federal taxes. And remember the Section 199A QBI deduction? That gets reduced by $7,440 for each partner, resulting in a reduced overall benefit of $4,464 – $893.
Why Bother When SALT Limit’s Not Around?
You might wonder if PTET is still worth the excitement when there’s no SALT limit. But guess what? It’s still a good deal. Reducing your income on your Federal K1 also means you’re cutting down the SE tax you’ll have to pay. And the IRS? They’re cool with it, as confirmed in their 2020 Notice.
Just keep in mind that PTET doesn’t tackle property taxes or state income taxes on personal wages. This is all about state income taxes on your PTE’s income, which would otherwise make a pit stop on your personal tax return.
So, there you have it – PTET, the ingenious way to outsmart the SALT cap and keep more of your hard-earned money in your pocket. Just remember, while tax magic can save you a bundle, consulting a tax professional is your magic wand for navigating the tax labyrinth.
Bradford Tax Institute