Pass-Through Entity Tax 101
Potential Tax Savings for Practice Owners
As a practice owner, you receive income from a pass-through entity (PTE) as your practice is separate entity from you individually. Generally, PTEs are not subject to an income tax at the entity level for federal or state income tax purposes. Instead, a PTE passes through its profits or losses to its owners, and the owners are taxed on their share of the PTE’s income or loss at the individual level. Prior to 2018, the income tax you paid to your state was fully deductible in calculating your Federal taxable income.
Since the Tax Cuts and Jobs Act of 2017 (TCJA) limited an individual’s state and local tax (SALT) deduction to $10,000, states have been exploring pass-through entity tax workarounds in response. Fast forward to November 2020 when the IRS gave guidance to allow state tax deductions at the pass-through entity level and opened the floodgates to states enacting pass-through entity taxes in the ensuing months, with 29 states now having new PTE tax bills.
Here is a quick summary of how the PTE tax works in general (Note that each state has developed their own system).
Your practice (the PTE) pays an entity-level tax on its income (generally at the highest state tax rate).
The income tax paid is fully deductible as a business expense in computing PTE’s income for federal purposes. We recommend paying the tax before the end of the year to get a deduction in the correct tax year.
As a result, the PTE income that passes through to your individual return is reduced by the full amount paid to the state. This is the workaround created to avoid the $10,000 SALT limitation.
By contrast, if the practice does not pay income tax at the PTE level at the state level, then you will be taxed on the PTE income at the individual level. Such tax would be subject to the $10,000 SALT limitation.
The state will then issue you a credit or income reductions for your personal state income tax return to offset the amount paid by the PTE.
Therefore, the tax amount paid to the state is not changing in total but is coming from the practice for the practice income and from you personally for all other income. The benefit comes in getting a full deduction for the tax paid related to the practice income on the Federal level.
As straightforward as it sounds, it really is far from it. This is due to every state having different regulations and not every practice reaping the same benefits based on profitability. If you are interested in taking advantage of this new option, please contact us to analyze the specific benefits for your practice.