Improper planning may result in a significant loss of tax savings, so careful consideration should be given to when the PTET liability is deductible, since that could occur either before or after the closing date. Taxpayers considering a transaction involving a PTE should review the applicable state law to determine potential tax benefits and whether the PTET regime requirements have been met or can be met in the future. State law may also limit the types of PTEs that can make a PTET election, and eligibility issues may affect the PTE’s value at sale. The answer to the timing question may, in turn, influence who ultimately receives the PTET benefit. State law governs when and how a PTET election is made, which may impact the year in which a taxpayer can deduct a PTET payment. The details of the state law authorizing the tax are critical to understanding the potential impact of a PTET election on a transaction. The effect a PTET election has on a transaction depends on many factors, including the applicable state PTET law, timing of the PTET deduction, type of PTE entity involved, and whether assets or ownership interests are being sold or purchased. However, questions remain regarding the tax implications of PTET elections, particularly in M&A transactions. The IRS provided guidance on the federal tax treatment of PTET payments in November 2020. Because the SALT cap doesn’t apply to taxes assessed at the entity level, the PTE can typically take a federal deduction for its entire PTET payment. Under these regimes, the PTE pays its owners’ state taxes and takes a deduction equal to the tax paid, while the owners receive a credit or exclusion of state income equal to their state tax liability. That is, pass-throughs must pay a 6.2 percent tax on their earnings and withhold 6.2 percent of their employees’ wages at each pay period.A growing list of states have enacted laws allowing pass-through entities to elect into pass-through entity tax regimes as a workaround to the $10,000 federal cap on state and local tax deductions for individual taxpayers.
Many pass-throughs (especially sole proprietorships) must calculate their Social Security and Medicare taxes as “self-employment taxes.” In pass-throughs with multiple employees and owners, owners are required to calculate their own payroll tax liability, both on the employer and the employee side. Pass-through businesses also pay self-employment taxes and state and local taxes.
What Other Kinds of Taxes Do Pass-throughs Have to Remit? In a partnership or S corporation, the tax is determined by percentage share of net profit. For a sole proprietorship, the tax is calculated on the owner’s total net income. Then, each person includes their portion of the business’ net income on their tax return. To determine their liability, the business first calculates its net income, or gross income less deductible expenses (see Sec. Instead, the profit is “passed through” the business and onto the tax returns of the business owners. When a pass-through business earns profits, it does not directly send a portion of the profits to the Internal Revenue Service (IRS). Pass-through businesses account for over half of business income in the United States and employ over half of the private-sector workforce. The vast majority of companies in the United States are pass-through businesses: 28.3 million out of the 30.8 million private business establishments that operated in the United States in 2014. That means that pass-through businesses pay individual income taxes, not corporate income taxes.
By contrast, pass-throughs simply shift their gains or losses to the owners or employees, who then report the income to the IRS and pay tax accordingly. In the tax code, corporations pay tax at both the entity level and again when they distribute earnings to their shareholders. While corporations are legally separate from their owner(s), pass-through businesses are legally synonymous with the individuals who own them. How is a C Corporation and a Pass-through Business Different?
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