The 2017 federal tax reform law included a provision which, which limits the state and local tax itemized deduction for individuals to $10,000 a year. Since then, state legislators and tax experts have been exploring ways to circumvent this limitation.
There have been many attempts to enact legislation (referred to as a SALT workaround) and the most successful strategy is for states to enact legislation to allow pass-through entities to pay tax at the entity level, shifting the tax on the pass-through income from the owner to the pass-through entity. This methodology requires that state income tax is paid by the pass-through entity directly, which is not limited in the amount of state taxes that it can deduct for federal purposes. Therefore, the tax is deductible without limitation via the net taxable operating income passed through to the owner. The IRS has stated its approval.
Alabama and Georgia have enacted similar legislation as the trend is catching on.
This month, Georgia has enacted legislation to allow an S corporation or partnership to pay state income tax at the entity level. This annual irrevocable election will be available for tax years beginning on or after January 1, 2022. The tax rate for this option is 5.75%, generally the highest Georgia marginal income tax rate. By making this election, the owners of pass-through entities will not have a filing requirement in the state, but they also will not receive an amount to credit for taxes paid to other states on their individual state returns.
Additionally, for tax years starting January 1, 2021 or after, S corporations and Subchapter K pass-through entities also have a pass-through entity tax option in Alabama, as provided for in the Alabama Electing Pass-Through Entity Tax Act (Act 2021-1).
If a qualifying pass-through entity wishes to make this election, the due date is the original due date of the return to which it is applicable. Like Georgia, the tax rate applicable will be the highest Alabama marginal income tax rate. A cost to this though is the loss of the federal income tax deduction attributable to the pass-through income. So, this increases the effective Alabama rate from 3.15% to 5%.
It is important to note that if a pass-through entity anticipates making the election for the 2021 tax year, estimated payments may be required during 2021 to avoid interest and penalties on underpayment.
Learn More about Pass-Through Entity State Taxes
Although simple in concept, every state with a pass-through entity tax has a different methodology of application, so suitability needs to be assessed for each taxpayer’s unique situation for each state where the election is available.
If you own a pass-through entity and would like to know more about the applicability of these taxes to your individual tax situation, connect with your Warren Averett tax advisor.