If your construction business is structured as a partnership, limited liability company or S corporation, don’t overlook the potential benefits of a state’s pass-through entity tax (PTET).

Nearly every state with a personal income tax has enacted or is considering enacting an elective PTET as a workaround for the $10,000 federal limit on deductions of state and local taxes (SALT). If your company’s partners or shareholders have substantial state income tax liabilities, a PTET may provide them with significant tax savings.

However, electing a PTET isn’t necessarily a no-brainer. In some cases, it can increase business owners’ state tax liability. And administering the tax can be complex for contractors who work on projects in multiple states.

Where it came from

The Tax Cuts and Jobs Act of 2017 imposed a $10,000 limit on SALT deductions by individual taxpayers for federal tax purposes, effective from 2018 through 2025. The cap substantially reduces itemized deductions for many taxpayers — especially those in states with high personal income and property taxes — causing their federal tax liabilities to rise.

To soften the blow, states began to create a variety of creative workarounds to help taxpayers in their states circumvent the $10,000 limit. The IRS rejected most of these solutions but, in 2020, it gave its blessing to the PTET concept.

How the tax works

The mechanics of each PTET vary from state to state, but a typical tax works like this: An eligible pass-through entity elects to pay tax on income derived from business activities in that state — usually, but not always, at the highest individual income tax rate. The entity’s shareholders or partners receive a state income tax credit equal to their pro rata share of the entity’s tax liability to offset their individual state taxes on the same income. In other words, they avoid double taxation.

Essentially, a PTET shifts liability for state income taxes from the individual owners to the entity. But unlike the individual owners, who are subject to the SALT limit, the entity can deduct the full amount of the state taxes as a business expense on its federal tax return. Doing so reduces the amount of income that flows through to the shareholders or partners.

The financial result for the business owners is roughly the same as if they’d paid state income taxes themselves on their pro rata shares of the entity’s income and then fully deducted them on their federal returns with no limit.

And now, the fine print

As noted above, precisely how each PTET works varies depending on which state(s) you operate in. That’s why it’s important to evaluate the potential impact — both positive and negative — on your construction business and its owners’ financial situations before making the election.

States have different rules about which entities and owners are eligible. For example, in some states, eligibility is limited to entities whose owners are individuals, estates, trusts or corporations — but not partnerships. Others limit eligibility to entities whose owners are all individuals. Some states have no restrictions at all. Ineligible entities may be able to restructure themselves to qualify.

Some states permit shareholders or partners to decide whether they’ll participate in the PTET. In those states, the entity pays the PTET on their consenting owners’ pro rata or distributive shares of the entity’s net income, and the consenting owners receive a corresponding credit. In other states, the entity must decide as a whole whether it’ll file a PTET election on behalf of the owners. The rules for making this decision vary from state to state.

Decision criteria

In deciding whether to make the election, it’s important to consider the impact on owners’ state tax liabilities. Depending on the mechanics of the credit, and the rate at which it applies, a PTET can increase those liabilities in some cases.

For instance, if owners receive a refundable credit for the full amount of their pro rata shares of the PTET paid by the entity, from a state tax perspective, they’ll be in the same position as if the election hadn’t been made. Some states offer only a partial credit; for example, 80% of the PTET. There are also states where the credit is nonrefundable — though it may be carried forward indefinitely or for a specified number of years. In other words, depending on state law, the PTET may increase some owners’ state taxes, which must be weighed against the benefits of avoiding the SALT deduction limit.

There are other factors to consider as well. As mentioned, multistate tax and administrative issues can be challenging. For instance, does your primary state offer residents a credit for their pro rata shares of a PTET paid in other states? On the administrative side, you’ll need to make the initial election, file entity and individual tax returns, and keep up with estimated tax payments.

Not a simple decision

Under the right circumstances, claiming a PTET can generate tax savings for eligible construction companies. But determining whether it’s the right move for your business is far from a simple decision. If interested, work closely with your CPA to explore the idea.

The state of PTETs

As of this writing, the state of pass-through entity tax (PTET) legislation nationwide is as follows:

States with a PTET*:

Ala., Ariz., Ark., Calif., Colo., Conn.,† Ga., Hawaii, Idaho, Iowa, Ill., Ind., Kan., Ky., La., Mass., Md., Mich., Minn., Miss., Mo., Mont., N.C., Neb., N.J., N.M., N.Y., Ohio, Okla., Ore., R.I., S.C., Utah, Va., Wis., W.Va.

States with pending PTET legislation:

Maine, Pa., Vt.

States with a personal income tax but no PTET**:

Del., N.D.

States with no personal income tax:

Alaska, Fla., Nev., N.H., S.D., Tenn., Texas, Wash., Wyo.

* New York City also has its own PTET.

** Washington, D.C., also has a personal income tax but no PTET.

Connecticut’s PTET had been mandatory but became elective in 2024. All other states’ PTETs are elective.

© 2024

Icon for Thompson Greenspon
Thompson Greenspon

This blog post was provided by Thompson Greenspon. If you have questions or concerns regarding this content, please contact us.