Are Pass-Through Entity Taxes Right for Construction Companies?
As the list of states enacting pass-through entity taxes (PTET) continues to grow and the possibility of electing into multiple regimes becomes an option, many considerations should be reviewed to ensure these taxes achieve the benefits your company seeks. While many construction companies or contractors want to take advantage of PTETs as a way to bypass the federal cap on state and local tax (SALT) deductions, they may not necessarily be the right option for all taxpayers.
Below are various factors to consider and questions that should be addressed before making a PTET election. Failing to work through these points could cost a taxpayer significant dollars, potentially putting them into a worse financial position than had they done nothing at all.
How is the PTET calculated? Many PTETs are skewed to benefit in-state partners by calculating the tax for residents on their pro rata share of total income, whereas for nonresidents the tax is on only state apportioned income. Because of this methodology, PTET credits and federal deductions tend to be higher for resident partners than nonresident partners, generating the need for special allocations of these tax attributes among the various partners to reflect the economic realities of the PTET. For S corporations, special allocations are problematic since the federal rules require all shareholders to be treated equally (e.g., one class of stock). Therefore, determining how the PTET is calculated and contending with the actual economics may be challenging for certain pass-through entities.
Is nonresident withholding still required if electing into the PTET? Having to pay PTET and nonresident withholdings can create significant cash flow problems for many construction businesses. Essentially, such situations can result in having to pay out double tax for which the overpayment will ultimately be refunded once the partners file their personal returns claiming both payments. Less cash on hand could hamper a business’s ability to effectively operate and can lead to constraints on investing in growth opportunities.
Does one get a full PTET credit or is it limited under the state’s rules? Most state PTETs allow taxpayers a 100% credit for the respective state’s PTET. However, some states reduce the credit available that a taxpayer can claim to 90% or less. Electing into these PTETs consequentially raises taxpayers’ effective state tax rates costing them additional monies while reducing the net benefit of the SALT workaround.
Can PTET partners claim a credit for another state’s PTETs on their resident state return? Because states can impose tax on all income of a resident, states generally permit a credit for taxes paid to other states to eliminate the prospect of double taxing the same income. However, some states do not afford this credit when the taxes are paid by an entity on behalf of a partner. Accordingly, taxpayers may have PTE taxes paid in but might not get a credit on their resident state return resulting in an additional tax liability they would not have had if not electing into PTET.
Will an investment partnership benefit from the PTET? Typically, expenses incurred by an investment partnership are deemed to be investment expenses subject to certain deduction limitations. Further, PTET expenses are likely to be considered ordinary business expenses that cannot offset investment income or may even be subject to the rules for loss limitations. Based on the interplay of these rules, there is a significant concern that despite electing PTET, an investment partnership’s partners may not see a significant reduction in their current year tax liability.
Are PTET refunds subject to federal income tax? For federal tax purposes, state tax refunds are often treated as “accessions to wealth” and therefore subject to federal income tax. Due to rate differentials between PTETs and personal income tax rates, as well as the prospect of other losses reducing one’s federal taxable income, PTET refunds are a strong likelihood. If such refunds are being taxed in a subsequent year, it is important to consider whether or not the PTET is really worthwhile in the current year.
How are composite returns impacted when electing in to a PTET? Many construction companies file composite or group returns on behalf of nonresident partners in states where the company is doing business to help partners avoid having to file and pay personal tax and estimates for relatively small amounts. Unfortunately, not all states with a PTET allow composite or group filers to claim the PTET payments as credits, thereby necessitating the individual partners themselves to file nonresident income tax returns to claim the PTET credit.
The above are just some of the many components to be analyzed prior to making a PTET election. Modeling the scenarios to identify the savings and costs will allow for a better understanding of the overall tax saving strategy. To determine whether PTETs are right for your construction company, please contact Phillip Ross or Joseph Molloy at Anchin.