Podcast | PTET: Pass-Through Entity Taxation

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Transcript

Andrea Sardone
In today’s episode, we’ll discuss PTET (Pass-Through Entity Taxation). If you’re a business owner, you’ll want to listen to our PBMares expert discuss the ins and outs of this vital topic. Our guest today is Lori Roberts, Tax Director at PBMares. She leads the PBMares state and local tax efforts, also known as SALT, and has a deep knowledge of state, local, and federal taxation issues and how they relate. Lori is adept at helping many clients find the best answers to their business and tax situations while remaining fully compliant and taking a proactive approach to maximizing tax benefits. Hi Lori, Thanks so much for joining us. It’s great to have you.

Lori Roberts
Hi Andrea. Thank you. Happy to be here.

Andrea
Many people don’t know what this topic is called, but they’re probably affected by it. So, let’s start with some fundamentals. What is a pass-through entity?

Lori Roberts
A pass-through entity is simply a business entity that instead of paying its tax at the federal level, the income passes through to the owners and eventually lands on the individual owner’s tax return. From there, the income is reported, and the tax is paid. A pass-through entity is unlike a corporation, which will file a tax return to pay tax on its behalf or a sole proprietor that files a Schedule C within Form 1040. Again, the income is reported there, and the tax is paid there.

Andrea
Okay, so the taxation part, so that’s the pass-through entity taxation. Are you saying that it could?

Lori Roberts
Well, that’s not what we really mean now, but we’ll get into that. However, in a pass-through entity, the income passes through to the individual owners or to the respective owners. They report the income there and pay tax on that return. So partnerships as corporations are pass-through entities.

Andrea
Okay. So our firm, PBMares, is that a pass-through entity?

Lori Roberts
Yes. PBMares files as a partnership.

Andrea
Partnerships, other types of partnerships, a lot of professional services, lawyers, law firms. Okay.

Lori Roberts
Yes, many law firms and closely held businesses file as partnerships or corporations because this creates a much better synergy for the owner to manage their assets. But that’s kind of getting off of what we want to talk about today.

Andrea
Well, but you know how you and I always talk about stuff and that’s what makes it fun. All right. So has this always been in existence? Have there always been these pass-through entities?

Lori Roberts
Pass-through entities have existed since taxes began.

Andrea
Okay, but then the tax part of it, the PTET. Tell me about that. What happened there? How did this new thing come about?

Lori Roberts
The PTET, pass-through entity tax, is very new. Okay, let me tell you a story. Actually, it’s not just a story, it’s fact.

Back in 2017, when the Tax Cuts and Jobs Act was passed, in order to make things come together financially for the federal budget, they enacted what’s known as a SALT Cap. That SALT cap restricts individuals, people like you and me, from deducting more than $10,000 in state and local taxes on their individual returns. So this would be state income taxes, real estate taxes, personal property taxes, that sort of thing, limited to $10,000. Well, for the pass-through entity taxpayer, that is paying taxes in their personal return, and actually for many, many taxpayers, this was a huge hit. So immediately upon passage, states began gnashing their teeth. What can we do to get around this and try to figure things out? And what evolved from that? Connecticut was the first state to do it. They thought if we permit or facilitate taxation on these pass-through entities at the state level, it becomes a tax on the entity and, therefore deductible on the entity’s federal return. Now the owner gets the benefit of that tax deduction because it’s deducted on their business return, not in their personal return, where it can’t be deducted.

Andrea
So the federal government did one thing, the Tax Cuts and Jobs Act. And then the states kicked in. So what I know about state governments and federal governments all have different rules.

Lori Roberts
51 you’ve got to remember the District of Columbia.

Andrea
We have 51 different state tax codes. When do you sleep? You’re always sorting this out, right?

Lori Roberts
We have some wonderful research resources, and you learn not to rely too much on your memory, and you look things up. There are certain commonalities between states, or among states, as to how they treat things and that kind of thing. There are patterns, because even though they all do their own thing, there are a lot of nuances.

Lori Roberts
They look at each other like, how do we do this? How are we gonna figure this one out?

Andrea
So they all kind of cooperate and take advice from their friends, right?

Lori Roberts
Well, yeah. Or they’re like, Oh, hey, they did that in Georgia. How did Georgia do it? Or how does Iowa do it or how did Connecticut do it in the past? Because they were first. Connecticut was the first.

Andrea
Connecticut was the first. So which is the hardest state? Is there a ranking? Like, you know, this state’s better. You know, I want to get into that. You don’t play favorites.

Lori Roberts
Some states have posed more of a challenge than others. A lot of times, that’s more a case of it’s different from. I live in Virginia, and most of my clients are based in Virginia, so I know Virginia pretty well.

I also sat on the committee with the Virginia Society of CPAs, coordinating with the Virginia Tax Department and then entering the legislature when Virginia was doing its PTET legislation. So, when I get to a very different state like North Carolina, I need to ask and check it out. So that will happen. Also, we’re always very careful with California.

Andrea
Okay, so let me ask you a question. Let’s say I own a business and I am in four states, or let’s just take our firm. We have offices in three states and more than that. So how does a company, a firm, or a pass-through entity juggle five states?

Virginia is the easiest state, but do you have to reconcile all of the state and local tax statutes somehow? How do you do that? What would a multi-state entity have to go through?

Lori Roberts
What we do for a multi-state is first, we work up what we need to work up for the federal return. Then, for the states, there’s a concept called apportionment. With that, we take three main components: sales—that’s the grocery sales to the company—payroll—their people, their workers. And of course, that has really proliferated causing a lot more companies to have to file multi-state because they have remote workers. That’s become very, very common, very popular now. So payroll, and then the last thing is property. And that’s either property you own, like cars or trucks, or property you rent, like offices or warehouses or things like that. For those components, we apportion the sales state by state based on each state’s rules.

The same goes for payroll; that’s pretty straightforward. The property and rents are also pretty straightforward. The sales can get interesting because states have different methodologies. But we say, okay, these are the sales for Virginia, these are the sales for Maryland, this is for North Carolina, this is for Iowa, and this is for California. And we’ve got clients with 40 states and their returns.

And so that’s how we do it. So it’s not mind-boggling. Our software helps us out a lot. And so, yeah, then we slice and dice.

Andrea
So I want to go back and maybe catch up on something because you said something, and it just dawned on me. So the pandemic hit, and then we had remote workers, and so I know our firm. We’ve hired people, one of whom is in Texas. So does that mean now we are subject to three and two? Okay, we keep hiring because we’re on the move. So we have a person in Texas, and we’re providing services, so now we’re subject to Texas tax.

Lori Roberts
Texas franchise tax, yes, which is a little bit different from income tax. Texas is different. Texas is Texas, you know. But yeah, they have a franchise tax. It’s not quite the same as a calculation for income tax, but it’s similar. So yeah, there’s the firm, our firm, and we have a lot of clients that have to file in Texas.

Andrea
All right.

Lori Roberts
Because they have people there, they have things going on there.

Andrea
Okay. I want to ask one more question, and then we’ll get back to some other fundamentals. So what happens if, is it just like everybody else? If you forget to pay your taxes in one state, or if you get it wrong, I mean, what are the big penalties?

Lori Roberts
It depends. If a taxpayer doesn’t have any, what we might say, hooks in the state, we do make decisions with clients like, yeah, you really don’t have a lot going on there. We’re not going to, you know, maybe don’t need to worry about that. Or you’ve got an employee there; you’re filing payroll returns, they got your number, you know.

You need to be doing it. A number of states have what we call factor presence, which has actually given us a nice bright line. If you have sales into the state of more than $500,000, you’ve got nexus, and you need to file a return pay tax. Similarly, about $50,000 for payroll. So that helps us a lot. And it’s our professional judgment that we’re bringing into.

Andrea
Okay.

Lori Roberts
You know, making those determinations.

Andrea
I know that you always advise clients in their best interest and make sure that they don’t get in trouble.

Lori Roberts
We want to avoid it. We want to avoid it, and there’s actually a process. Sometimes when new clients come on board, we find something out that a client wasn’t filling us in on. The states have processes called voluntary disclosure, and that’s when we go in and we’ll say I have a client that should have been filing taxes in your state.

We want to go on record. Please tell me what we need to do next. And, you know, usually it’s like, okay, you know, fill out this form or give us their name and tax ID number and in those cases, the penalties will be abated, the taxpayer pays their tax, they pay interest on the delinquent tax, and life goes on.

Andrea
Right. Usually, if you say, okay, I made a mistake, they’re pretty good about that. It’s always better to do that.

Lori Roberts
If you come forward. But, if the state sends a letter first saying, we think you owe taxes, you’re not going to be able to do that voluntary disclosure. There’s going to be penalties. They can go back many years. And that’s the kind of thing we’re weighing out with clients.

Andrea
Once you’re on the radar, it’s like, okay, we’re gonna start looking into this. So it could be a little less forgiving. So now we know the relationship between SALT, state and local taxes, and pass-through entities. So going back to this $10,000 cap, who sets that? I mean, how did they come up with $10,000?

Lori Roberts
Absolutely. Yes. It was Congress. I’m speculating, you know, they figure out what’s going to be the cost to the federal government if they implement one thing versus another and they do the calculations. And so they came up with that. And, of course, with the Tax Cuts and Jobs Act, one of the big goals was to work to simplify…..

Andrea
Okay, okay, so the federal government gets back in.

Lori Roberts
…the federal tax code or the federal tax compliance. So they dramatically raised the itemized deductions for individual filers, which made it that many, I forget the numbers, but individual filers no longer benefited from itemizing their deductions. They were better off to take that standard deduction. And so the salt cap didn’t matter. And so the salt cap is impacting predominantly people in the coastal states. California, Oregon, New York, New Jersey, Maryland. Virginia. Connecticut. That’s where the biggest impact of that salt cap is because that’s where, you know, those are our big centers of commerce and where you have people making a lot of money. And expensive real estate and high real estate taxes.

Andrea
So, what happened in late 2020?

Lori Roberts
Okay, so the Tax Cuts and Jobs Act was passed in 2018 or 2017. After that, states were like, oh, what can we do to help the people of this state save tax money? Another thing that they were somewhat concerned about is they didn’t want people and companies leaving their state with high taxes and moving to Florida, where there is no income tax, no state income tax, so Nevada and a couple of other states.

So anyway, they’re working at it. In late 2020, November of 2020, the IRS came out with the notice, 2020-75. I’ve read through this in parts and the ins and outs so many times; that’s why it’s probably the only tax notice I know by number. But anyway, 2020-75 said and affirmed from the IRS that the state passed through entity tax, these PTET regimes are okay. There is a good basis for that, but it was very general. Not a lot of specifics. It doesn’t hold the same weight and heft as the tax code, and the tax regulations do, or even a tax case, but this is from the IRS. So that just opened the floodgates for states to get going, looking into and implementing their PTET regimes.

Maryland came on board with theirs, effective for 2021. And this is a fun story here. You know, this is in 2020 as COVID started to come at us, and we’re all, everybody’s panicking and like, oh my gosh, there’s storms out there, we gotta go home. So that apparently the Maryland legislature passed this COVID bill rush so that they could stop their session and everybody could go home and be safe. So were a couple of major flaws in that bill. And then, they had to come back and do some emergency legislation the following year to fix them. But anyway, Maryland implemented their PTET rule in 2021. Many states, including Virginia and North Carolina, implemented theirs for 2022. And actually, Virginia has a throwback that still hasn’t been fully released yet that we’re going to be able to go back and do things for 2021.

It just opened it up. And then since then, I think there are only about four or five states with income taxes that haven’t implemented a PTET program—only five. So it was like opening the floodgates.

Andrea
You said something – just for my understanding and those listening: When the IRS issues these, what are they called? Notices?

Lori Roberts
Notices.

Andrea
Then it’s like, they’re always retroactive, or it’s like, okay, now we’re gonna go back. It just depends.

Lori Roberts
It just depends on the issue that they’re trying to address. In this case, the notice basically said that state pass-through entity taxes or taxing pass-through entities at the state level are okay; it’s deductible in the federal return. There were a couple of other elements in there, but there’s other stuff that, to this day, has us scratching our heads or kind of, hmm.

But we’re doing our best to navigate it because the IRS has not issued regulations the way they said they would. So we’re just working to navigate that.

Andrea
Okay. So sometimes, the IRS doesn’t make sure that everything is checked. They kind of do, and then they go back, and yeah. Okay.

Lori Roberts
Some. That’s right, or they put something out there and then once the tax world starts working with it and practitioners are working with it, we’re like, well, what about this or what about that or well, you know, or this is a weird, and then they come up with regulations, or they revise them so I’ve noticed that.

Andrea
Yeah.

Lori Roberts
Sometimes, the law is intentionally general, but then the IRS is instructed to issue regulations to try to tighten things up.

Andrea
Let’s say I have a law firm with 15 lawyers working for me. It’s a partnership, but does that then make me a pass-through entity by definition, or do I get to choose to be one?

Lori Roberts
So by definition, you formed a partnership, or maybe an LLC, which is very much hand in hand. So right out of the gate, IRS, are you going to be required to file a partnership return form 1065? However, your partnership may elect to file as an S-corporation.

This means it’s still a pass-through entity, but it has slightly different rules and probably more than you really want to go into the weeds with right here. But a lot of partnerships, not necessarily law firms and the like, will stay as partnerships, but a lot of businesses will benefit from filing as an S-corp as opposed to a partnership. So there are benefits, pros, and cons to that.

Andrea
Working with wonderful people like Lori, I know that this is not something we’re going to explain in our podcast here, but we have all sorts of experts like Lori and her colleagues who can explain it. I would say that the best bet is to talk with a professional because you don’t need to go it alone.

Lori Roberts
Consult your tax advisor.

Andrea
There is a benefit to electing into PTET. Do they mean you’ll save X percentage of taxes, or does it just depend?

Lori Roberts
Yes. It depends. You know our favorite answer: It depends, yes. Okay, but the biggest deal and the really quick response is: Let’s say you have a business owner whose business makes a million dollars, and they’re gonna pay tax on the million dollars. If they elect, and we’re gonna pretend that this business is solely in Virginia, no place else.

Andrea
It depends.

Lori Roberts
Okay, and it would be a similar outcome if they were in Maryland or if they were in North Carolina. They’re in Virginia, and they elect to pay the past through entity tax, the PTET. That PTET on those Virginia owners is going to be 5.75% or fifty-seven thousand five hundred dollars.

Lori Roberts
Anyway, they’re going to deduct that on their business tax return and pay the federal return when they pay that. That means their income passing through in the K-1 will be much less. So they will have that much less income in their return to report and pay tax on at the federal level, their federal return.

That’s where they see the savings. Now, things get a little bit more complicated when you get to the state return because, hey, you’ve already deduced that federal tax or that tax on the federal return, you add it back in the state return, but then to avoid paying the tax twice, we come around and we take a state tax credit. And that’s where our clients throw their hands up figuratively and say, you figure it out.

The savings are federal tax savings, but the manipulations are done at the state level. So we have clients saving tens of thousands of dollars in federal tax because of PTET, especially at the very highest federal rates, 37%. It’s a big savings.

Andrea
Okay. I will see if I can summarize what we just talked about. And you tell me if I got this. Don’t hold back because I know you won’t. Pass-through entities like LLCs and S-Corps can avoid double taxation by not paying corporate income tax.

Lori Roberts
Okay. Yeah, they save; yes, they save the double taxation. And let’s say partnerships and S-corps save the double taxation. Double taxation, which we haven’t touched on previously, is where the corporation pays tax. Then when the corporation pays dividends to the owners, those dividends are taxable to the owners. That’s a traditional corporation corporate tax.

But the pass-through entities, as you said, they take all of that income, and they issue their owners a K-1 and the owners report the income and their returns.

Andrea
Okay, let me restate that. Instead, their profits and losses pass through to the owner’s personal tax returns, who pay tax at an individual tax rate.

Lori Roberts
Correct.

Andrea
There are pros. What are the cons? Are there any cons here? Is there anything, and I want to make sure that everybody who’s listening is like, Lori’s not guaranteeing anything? She’s just kind of given us sort of a general idea here. Again, the best way to get something specific to a person, an individual, is to talk to an advisor. But what about the cons?

Lori Roberts
Talk to an advisor, and I say, we’re kind of drifting more into the entity selection when we’re talking about corporate versus pass-through. So that’s kind of a whole conversation about what makes sense. Either me or one of my good buddies here at the firm. It is invaluable.

Andrea
So you’ll come back and talk to me about that, right? Okay, we’ll get both of you. I love talking to you guys about this.

Lori Roberts
But once the decision for the pass-through entity is established and that’s the tax vehicle, it’s very attractive to consider the pass-through entity tax and the benefits that can be derived there.

Andrea
I think I got this. I’ll probably come back to you again. I want to have you back. Is there anything you want to tell listeners? Your multi-state entity pass-through people.

Lori Roberts
Well, in multi-state, we can investigate and deal with pass-through entities with multiple-state returns or figure out what makes the most sense. But it all comes down to two things. The best advice I can give is two things. One, consult and confer with your tax advisor. Get into the conversation, more so than send me stuff.

Send us stuff right now so we can complete your tax return in the next couple of weeks. You know, ongoing and tax planning can be very beneficial, and it gives us so much better opportunity to help work through and provide tax savings and not just tax savings, but here’s my second thing: don’t let tax drive the bus.

You will go broke if you let tax and tax savings control all your decisions. You want to focus on being tax efficient and increasing wealth overall. If you don’t keep the money in your pocket because you’re spending it here, there, and everywhere, and this is where I can go into buying good drugs to try to get a Section 179 deduction, you want to increase, you want to focus on wealth. And then take step-tack strategies to facilitate.

Andrea
Okay, that’s good, and I know that all of our partners and team at PBMares are always looking for the client’s best interests and helping. All right. Well, Lori, I want to thank you for this. This has been fun. I want you to come back and we’ll keep on going. So have yourself a great weekend.

Lori Roberts
Yes. All right, you too. You’re welcome, bye-bye.