The 2017 Tax Cuts and Jobs Act’s $10,000 limit on the state and local tax (SALT) deduction managed to survive attempts to reform or scrap the policy during the last Congress, but that hasn’t stopped states ignore it. If anything, state activity in this area has accelerated, even though the provision will expire after 2025 (whether it expires or is extended or reformedis a totally different question).
Although the US Treasury Department has rejected some attempts to work around the SALT deduction cap, states have a green light to provide tax relief for taxpayers with transferred business income.
Here’s how it works: Under federal tax rules, the $10,000 limit applies to all individual filers, including business owners who report earnings as pass-through income. However, C corporations, which pay taxes at the entity level, have no limit on their SALT deductions.
Therefore, many states have enacted laws that allow transfer companies to pay taxes at the entity level instead of the individual income tax returns of their owners or shareholders. All the company does is change the way it files its taxes, and then the owners or shareholders of the company can take the full SALT deduction against these earnings.
It’s not hard to see why the transfer entity tax (PTE) has become so popular among states. It cuts taxes for its residents and businesses without reducing state tax revenue. It is the feds who charge for the solution.
A widespread trend
Support for the policy is bipartisan. Currently, about 30 states have enacted a PTE tax, up from June 14, 2021. Connecticut became the first state to enact a PTE tax as a workaround for the SALT cap in April 2018. PTE taxes in Connecticut are mandatory, but elective in all other states.
State PTE tax structures and rules vary widely, which can lead to complications, especially for businesses that operate across state lines. Whether or not paying a tax at the PTE level reduces shareholders’ tax liability depends on each state’s tax rates, credits, and deduction limits for individuals versus PTEs.
If an election is held for a particular entity, the election is binding on all owners or shareholders for that fiscal year. But choosing PTE taxes may not always be beneficial to all individual shareholders. For example, non-resident shareholders may not be eligible to receive a state tax credit, depending on the laws of the state of residence.
How states account for this revenue is also complicated. For example, New Jersey and Virginia count income received from PTE taxes as part of personal income taxes, because that is where the income had previously been reported. Other states, such as California and Connecticut, count PTE income for business income taxes, while Wisconsin counts it for both individual and business income taxes.
(For an up-to-date list of states with elective PTE taxes and their effective dates, see Table A7 of our latest State Tax and Economic Review quarterly report.)
Understanding PTE Elective Taxes and the State Treasury
PTE taxes can complicate understanding tax and revenue trends in different states. Declines in personal income taxes may reflect weaker economic activity, but they may also be driven by this change in where taxes are filed.
Monthly tax data from the Urban Institute’s State and Local Finance Initiative can shed light on these issues. The following table shows PTE tax collection since enactment in six states. (In other states, PTE elective taxes are still being implemented and the data will not be available until after the end of tax filing season.)
California and New York have each collected more than $22 billion in PTE taxes thus far. Both states, as well as Michigan, have also seen decreases in their estimated personal income tax payments for the first ten months of 2022. This likely reflects a shift in accountability at the entity level, although the decline in the values of the shares may also have reduced estimated tax. Payments
PTE tax payments appear to have weakened in recent months. Most states require companies to decide at the beginning of the year whether or not to participate, so weakening over the years could reflect entities determining that the benefit was less than expected. Or weakening the results of companies or associations could be at work.
Opting for PTE taxes was expected to lower estimated personal income payments. Some states had waived the requirement that PTEs make estimated payments. However, some partnerships or S corporations may have been making estimated payments on a voluntary basis. Therefore, the full impact of PTE taxes on personal income tax payments will be much clearer when tax season ends.
Last but not least, it will take time for businesses and states to determine the actual benefits of the new PTE taxes and how it affects different owners. Until then, we will witness further volatility in income tax revenue streams, which could also become moot by the end of 2025 if the SALT cap expires.
