Taxpayers that itemize their deductions can deduct certain state and local taxes (SALT). These SALT deductions can include property, income, and sales tax. Although all three are eligible, taxpayers must choose between deducting income tax or sales tax, while property taxes are always eligible. In 2017, when the Tax Cuts and Jobs Act was signed, the previously unlimited SALT deductions became limited to $10,000. Many pass-through entity (PTE) owners located in states with high income taxes paid more than $10,000 in state income taxes alone. So, once the new limit was put into effect, many owners couldn’t deduct as much as they previously could on their federal tax returns.
In November of 2020, the IRS issued Notice 2020-75, which vindicated a workaround to this credit. This prompted many states that hadn’t already implemented an elective Pass-through Entity (PTE) tax to do so. In Minnesota, the new PTE tax election is available for an entity’s tax years beginning after December 31, 2020.
A Pass-through Entity (PTE) Tax allows entities to pay state income tax on behalf of their partners, members, or shareholders. The amount an entity pays is based on the highest state tax rate. In Minnesota, this is 9.85% for 2021.
When an entity elects to use the PTE tax, the entity owners can deduct the amount paid by the entity, at the state and local level, from their taxable income. This reduces the amount of federal taxes they owe. The deduction from the taxable income for federal taxes isn’t deductible on state tax returns, so the amount of state income tax paid remains the same. However, the state receives money from the PTE and not the individual. To reconcile the amount the entity paid, owners become eligible to claim a refundable tax credit. This credit eliminates double taxation because the state already collected the income tax for the taxpayer through the PTE.
Electing to pay a PTE tax doesn’t affect the amount of SALT credits a taxpayer is eligible to deduct. The taxpayer can still take advantage of the $10,000 in available SALT deductions.
The elective PTE tax is eligible to Partnerships, s Corporations, and LLCs taxed as an s corporation or partnership. If one of the owners (partner, member, or shareholder) is a partnership, LLC, or corporation, that entity is not eligible. Also, 50% or more of the PTE’s owners decide to pay the elective tax. Once it elects to pay the PTE tax, the Tax is binding for the entirety of the tax season and all owners.
How do entities elect to pay the PTE Tax?
For PTEs to elect to pay income tax at an entity level on behalf of their owners, they must complete Schedule PTE. Partners and shareholders who are residents of Minnesota must file Form M1 (for individual tax returns) or M2 (for estate and trust tax returns). If an owner isn’t a resident of Minnesota the entity can still pay their Minnesota income tax on their behalf. The nonresident only qualifies if they don’t have taxable income from Minnesota other than entities that file for PTE tax or entities that elect owners to be included on their composite tax return.