On June 14, 2022, Ohio adopted an elective pass-through entity tax to help business owners sidestep a $10,000 cap the IRS placed on state and local tax (SALT) deductions. While the pass-through entity tax (PTET) helps Ohio business owners recoup their SALT deductions at the Federal level, it created a new problem for owners of multistate businesses. But before we dig into this complex issue, let’s rewind back to 2017 to see where this all started.
Why did Ohio create a pass-through entity tax?
At the end of 2017, the US Congress passed a record-breaking tax bill called the Tax Cuts and Jobs Act (TCJA). The TCJA changed many facets of the tax code for both businesses and individuals. On the individual tax front, one of the changes it made was to limit taxpayers’ SALT deductions. Beginning in 2018, taxpayers could only deduct up to $10,000 of state and local taxes. (For most taxpayers, state and local taxes include income, personal property, and real estate taxes.) Taxpayers whose state and local taxes exceeded $10,000 were required to forfeit the remainder of their deduction.
Many states — including Ohio — addressed this issue by creating a pass-through entity tax.
What is a pass-through entity tax, and how does it help reduce the SALT cap?
A pass-through entity tax (PTET) allows the owners of partnerships, S corporations, and LLCs to “elect” for their income to be taxed at the entity level for state income tax purposes rather than pass that income down to the individual owners. By having the entity pay state taxes in lieu of the owner or partner, you’ve effectively transformed an individual-level deduction — which is currently limited to $10,000 — into a fully-deductible business expense. This ensures business owners get the full deduction for their SALT liabilities. Here’s how it works:
When the business pays the PTET tax liability, the business can fully deduct those taxes on its tax return. This deduction passes through to the shareholders as reduced taxable income on their K-1s. If owners don’t elect into the PTET, they would instead deduct those taxes on Schedule A of their Form 1040, and that SALT deduction would be limited to $10,000.
Ohio’s entity-level tax is voluntary, and owners must make the election annually.
What was the problem with the Ohio PTET?
Ohio residents are required to pay taxes on 100% of the income they earn, whether that income was earned in Ohio or some other jurisdiction. However, to ensure Ohio residents aren’t taxed on the same income twice, they can claim a credit for income taxes they’ve paid to other states. Until recently, Ohio didn’t allow business owners to claim a credit for PTET taxes made in another state. This meant that Ohio business owners who operated in multiple states were subject to double taxation.
How did Ohio lawmakers address the double taxation problem?
In July, Ohio signed House Bill 33 into law that now allows business owners to claim a credit for PTET taxes paid to other states. In effect, this tax law eliminates the double taxation conundrum that made the Ohio PTET unappealing to owners of multistate businesses. This fix, which the legislation refers to as the “resident tax credit,” is effective beginning in 2023, but business owners can amend their 2022 returns to claim those credits if they choose.
How should the PTET affect short- and long-term tax planning?
While the PTET is a good workaround to the $10,000 federal SALT cap, it’s not the right election for everybody, and there are a few administrative requirements you need to remember. When considering the PTET, here are a few things you should talk to your CPA about are:
- How the election will affect Ohio nonresidents. If some of your owners are nonresidents of Ohio, consider how the Ohio PTET election will impact their tax liabilities.
- How the PTET differs from the Ohio Composite Income Tax Return. The PTET is an entity-level tax. Ohio also offers a Composite Income Tax Return, which is where the entity files a return and pays taxes on behalf of its nonresident owners. Although the Composite Income Tax Return may look like the entity is paying the tax, it is simply eliminating the requirement for certain owners to file a state tax return; those owners are still the ones liable for their share of Ohio business earnings and the resulting tax.
- Difference in tax rates. The PTET applies a flat tax on all business income. This rate is 5% in 2022 and 3% in 2023. Consider how your owners’ individual tax liabilities would change if you made the PTET election.
- Making quarterly estimates. If you elect the PTET, your entity should be making quarterly estimates using IT 4738. If you’ve made estimated tax payments under IT 1140 or IT 4708, you should still be able to claim those as eligible PTET payments.
- Making the election on time. You must make the Ohio PTET election when you file your tax return (i.e., by April 15, 2024 for the 2023 tax year). Keep in mind that other states with PTETs have different election deadlines.
- The SALT cap expiry date. The $10,000 SALT cap is set to expire at the end of 2025. Know how the PTET election will affect your tax position both before and after the SALT cap sunsets.
The PTET election will affect more than just your and your fellow owners’ tax liability; it may also impact your financial statements. To fully understand the implications of making the PTET election, reach out to a CPA you trust for their advice. Our Meaden & Moore advisors are watching PTET legislation closely for changes that affect our client base and would be happy to see if the PTET election is right for you.
Additional information, including FAQs can be found here.
For more information about Ohio’s Pass-Through Entity Tax, reach out to us today.