SALT Cap Workaround – Ohio provides PTE investors who elect workaround with income tax benefit.
Individuals are limited to deducting $10,000 ($5,000 for married filing separate) of state and local taxes (SALT) on their Federal income tax. Generally, income earned by pass-through entities (PTE) is taxed at the investor level, meaning business owners lose a valuable Federal income tax deduction for state taxes paid on income earned by businesses they own. However, taxes imposed at the PTE level are not subject to the SALT cap limitation since these taxes reduce the investor’s distributive share of income reflected on Schedule K-1 and are not deducted directly by the investor.
By electing to participate in an Ohio composite return, individual taxpayers avoid the SALT cap on taxes owed on income earned by PTEs. Additionally, these taxpayers may receive a benefit from the increased rate paid by PTEs on composite returns (highest individual income tax rate – 4% currently) compared to that owed by the individual on business income (3% currently). With the income tax filing deadline approaching, PTE investors and their professionals should be aware of the risks and benefits associated with filing an Ohio composite return.
IRS specifies that elective PTE-level taxes avoid SALT Cap.
Many states have, or are considering, income tax structures which allow PTE investors to elect to have the tax imposed at the entity level and claim a credit against their state income taxes for their pro-rata share of taxes paid by the PTE. In Notice 2020-75, the IRS states that these elective PTE-level taxes, referred to as Specified Income Tax Payments, are treated as entity-level taxes and avoid the SALT cap. Specified Income Tax Payments are taxes imposed directly on a partnership or S corporation, regardless of whether the imposition is the result of an election or investors receive a credit or other benefit for the taxes paid.
The partnership or S corporation deducts the amount of Specified Income Tax Payments made during the year, which reduces the amount of income that ultimately passes through to its investors. Therefore, such payments are not subject to the SALT cap at the individual level. The IRS Notice is applicable starting with the 2018 tax year.
Ohio taxpayers can take advantage of SALT cap workaround by electing to participate in composite return.
Based upon IRS Notice 2020-75, PTEs filing an Ohio composite return and paying the associated tax operate precisely as Specified Income Tax Payments are described in the IRS Notice – PTE owners make an election to impose tax at the entity level and receive a credit for their distributive share of tax paid by the PTE. By electing to file a composite return, the PTE is liable for any taxes, interest, and penalties that may be imposed on the business’ income. R.C. 5747.08(D)(4). The key is the tax is imposed directly on the PTE, unlike a withholding tax which is imposed on the investor but paid by the PTE on behalf of its individual owners.
By making the election to file a composite return, Ohio income tax should be treated as imposed directly on the PTE. R.C. 5747.01(N). Even Ohio residents can avoid the SALT cap on income earned through PTEs as residents are permitted to elect to participate in a composite return, Ohio Form IT 4708.
Moreover, PTE investors may actually receive an additional benefit by electing to file a composite return. When making such an election, the PTE pays Ohio income tax at the highest individual rate (currently 4%) without accounting for certain deductions, mainly the $250,000 business income deduction. However, when the investor files his/her individual Ohio return, the investor would only owe tax at 3% with a $250,000 ($125,000 if single or married filing separate) deduction to the extent the PTE income is considered business income. R.C. 5747.01(B). Therefore, the investor would benefit from claiming the Federal deduction based upon the higher taxes owed by the PTE, while also claiming a credit for taxes paid by the PTE against income from other sources or a refund for Ohio individual income tax purposes.
Ohio’s composite return election provides Ohio individual income taxpayers owning PTEs with the ability to workaround the Federal SALT cap, although with some risk as the PTE assumes responsibility for taxes owed on the income reported. Although some may assert that Ohio’s composite return functions more as a withholding tax with tax being paid by the PTE on behalf of the individuals, such a position is inconsistent with Ohio’s statutory language of the composite election, which closely resembles that enacted by other states. Thus, since the Ohio income tax is imposed directly on the PTE as the taxpayer, investors in PTEs making the composite election may avoid the SALT cap on their federal return according to IRS Notice 2020-75.
Please contact us if you have questions regarding how you can benefit from Ohio’s SALT cap workaround.