A growing list of states have enacted laws allowing flow-through entities to opt into flow-through entity tax regimes as a workaround to the federal $10,000 cap on state and local tax deductions for individual taxpayers. Under these schemes, the PTE pays its owners state taxes and takes a deduction equal to the tax paid, while the owners receive a credit or exclusion from state income equal to their tax. to be paid by the state. Because the SALT cap does not apply to taxes assessed at the entity level, the PTE can generally claim a federal deduction for their entire PTET payment.
The IRS provided guidance on the federal tax treatment of TFWP payments in November 2020. However, questions remain regarding the tax implications of TFWP elections, particularly in merger and acquisition transactions. The effect of a PTET election on a transaction depends on many factors, including the applicable state’s PTET law, the timing of the PTET deduction, the type of PTE entity involved, and whether any assets or interests are being sold. or purchased.
Impact of state law
Details of the state law authorizing the tax are key to understanding the potential impact of a PTET election on a transaction. State law governs when and how a TFTE election is made, which may affect the year in which a taxpayer can deduct a TFTE payment. The answer to the timing question can, in turn, influence who ultimately receives the PTET benefit.
State law may also limit the types of PTEs who can elect a PTET, and eligibility issues may affect the value of the PTE for sale. Taxpayers contemplating a transaction involving a PTE should review applicable state law to determine potential tax benefits and whether the requirements of the PTET regime have been met or may be met in the future.
Timing of a TFWP deduction
Poor planning can result in a significant loss of tax savings, so careful consideration should be given to when the TFWP liability is deductible, as this could occur before or after the closing date.
The tax year in which a PTET liability becomes deductible for federal tax purposes may depend on several factors, such as whether the PTET is a taxpayer on a cash basis or of exercise and the steps the TEP has taken to opt into the TFWP plan by year. -end. A PTET liability is generally not deductible by a PTE on an accrual basis until the tax year in which the PTET liability is considered fixed and the economic performance has occurred, or an exception applies.
Similarly, the deduction for cash taxpayers may be affected by state law requirements and whether the PTE is legally responsible for paying the TFWP under state law.
Meeting the requirements for a TFWP liability to be deductible for federal tax purposes can be complicated, so taxpayers should evaluate these requirements carefully to ensure that the TFWP liability is deductible in the tax year. taxation provided for by the parties.
Transit Feature Types
Generally, shareholders of S Corporation prefer to sell shares rather than assets to ensure that the proceeds of the transaction are taxed at preferential capital gain rates. However, the situation is more nuanced when considering the sale of an S corporation eligible for TFWPs.
If Corporation S sells its assets and enters the TFTE regime, the state tax assessed at the entity level would not be subject to the SALT cap. The taxable income that passes through the shareholders of Corporation S would be reduced by the PTET deductions at the PTE level. If shareholders sold stock instead, state tax would be assessed at the shareholder level and any federal tax deductions would be subject to the SALT cap.
A sale of assets has additional consequences, such as the potential change in the tax character of the gain recognized on sale. That said, the availability of PTET deductions within the company should be considered, as deductions can result in a reduced tax burden for sellers. This would reduce the cost to buyers reimbursing sellers for their costs of adjusting to the sale of an asset.
Similarly, partners in TFWP-eligible partnerships who wish to maximize SALT deductions may prefer to sell assets rather than partnership shares. The SALT limit generally does not apply to an eligible federal tax deduction at the partnership level. Thus, a TFWP deduction associated with a sale of assets at the partnership level may reduce the taxable income allocated to the partners, thereby reducing the total tax cost.
If the owners sold shares in the partnership, the tax would be assessed at the level of the owners and would likely be subject to the SALT cap if they were individuals. The federal tax character of a sale of an interest in a partnership is influenced by the assets of the entity, so there are fewer differences between the interest and the sale of assets.
Partners do not always benefit equally from PTET deductions depending on state law, the purchase agreement, and the partnership agreement. Many partnership agreements do not distinguish between types of deductions, so taxpayers should review the agreements to ensure that they will receive the expected benefits from the TFWP.
Partners who receive guaranteed payments are particularly vulnerable to losing the TFWP benefit since the deduction can be allocated to other partners. However, they may receive an economic benefit since the burden of paying state taxes on guaranteed payments may be shifted from the partner to the partnership if the PTE election is made. Partnerships could reduce guaranteed payments to manage this.
Key points to remember
When considering a transaction involving an entity eligible for TFWPs, taxpayers should ask:
- What are the state law requirements for doing a PTET election, and can those requirements be met?
- When does the liability for the TFWP become deductible for federal income tax purposes, and is this before or after the transaction is completed?
- Is the PTE involved in the transaction an S corporation or a partnership?
- Is the transaction a sale of equity or a sale of assets?
Taxpayers contemplating a transaction involving an entity eligible for TFWPs should contact their tax advisor to discuss the circumstances of the transaction and potential tax benefits.
This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
mike monaghan directs the National Tax Service of Plante Moran. He specializes in handling the tax aspects of transactions and frequently plans the purchase, sale, creation and restructuring of businesses.
Tony Israels is a national and local tax manager for Plante Moran. He leads the firm’s national and local tax due diligence group and helps clients navigate SALT responsibilities and filing responsibilities in connection with their acquisitions and sales.
Jennifer Kegan is responsible for the General Tax Department of Plante Moran. She specializes in emerging tax issues and provides tax strategy and planning advice to clients on tax changes and developing areas of tax law.
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