State entity-level taxation has become a hot topic due to the significant limits individuals face when deducting state and local taxes on their individual returns.
Under current tax law, these deductions are capped at $10,000. This cap includes real estate taxes, property taxes, sales taxes, and state income taxes. For many taxpayers, particularly those in high-tax states, the limit means losing out on valuable deductions.
The problem with the $10,000 SALT cap
The $10,000 cap on state and local tax (SALT) deductions often leaves individuals paying more in federal taxes than they otherwise would. High earners and those with significant property holdings are particularly affected.
To understand the impact, let’s consider an example involving a North Carolina-based business that has to file a Georgia business return because it has operations there. The business is a pass-through entity, meaning that the business doesn’t file its own tax return—its income and deductions are claimed on the owners’ individual returns. The owners of this pass-through entity must report and pay Georgia state taxes on their individual returns. Because they must pay state taxes in two states, their overall state tax burden is higher than the average taxpayer’s. A typical federal return allows for the deduction of state and local taxes, but that deduction is capped at $10,000.
The composite return option
One potential solution offered by some states is the composite return. Under this arrangement, the state charges its tax, and the individuals pay it through an entity-level filing. The primary benefit here is that the individuals do not need to file separate state tax returns. Instead, they can file a single composite return, simplifying the process.
However, the downsides are : (1) the business may not deduct the tax paid, and (2) even though they are entitled to deduct the payment of this tax, the individuals are still subjected to the $10,000 tax cap. Again, if the tax liability is substantial, the lack of a deduction can result in a higher overall tax burden.
Entity-level taxation: A strategic alternative
Entity-level taxation offers a compelling alternative. Under this approach, the North Carolina-based business can elect to have Georgia tax the entity itself rather than the individual owners. The business is still considered a pass-through entity, even though it’s taking advantage of entity-level taxation. But, now the tax becomes a business expense, which is deductible at the federal level. Consequently, the individuals receive an indirect federal tax benefit because the business’s taxable income is reduced by the amount of the state tax paid.
Benefits of entity-level taxation
- Federal tax deduction: The primary advantage is that the state tax becomes a deductible business expense, reducing the federal taxable income of the business.
- Simplification: Similar to the composite return, entity-level taxation can simplify state tax filings, as the burden shifts from the individual to the business entity.
- Financial relief: For businesses with a state tax burden that exceeds $10,000, this method can offer significant tax relief by circumventing the $10,000 SALT deduction cap.
Considerations and potential downsides of entity-level taxation
While entity-level taxation can provide substantial benefits, it’s not without potential downsides. Each business must carefully consider the following:
- State-specific rules: Not all states allow entity-level taxation, and those that do may have specific requirements and regulations. The majority of states do allow for entity-level taxation, and some have pending legislation related to the matter.
- Increased complexity: Implementing and managing entity-level taxation can add complexity to the business’s tax planning and compliance efforts.
- No individual deduction: Unlike composite returns, individuals do not need to file individual state tax returns, but they also cannot claim the state tax as a personal deduction.
- Long-term implications: Businesses must evaluate how entity-level taxation fits into their overall tax strategy and long-term financial planning.
Practical steps for entity-level taxation
- Consult with a tax professional: As with any tax planning strategy, business owners should work closely with a tax advisor to understand the implications of entity-level taxation in their specific context.
- Evaluate state options: Research and understand the tax laws in each state where the business operates to determine the availability and benefits of entity-level taxation.
- Financial analysis: Conduct a thorough financial analysis to compare the potential tax savings against any increased administrative costs or complexities.
- Plan for compliance: Ensure that the business has systems and processes in place to comply with entity-level tax requirements, including accurate record-keeping and timely filings.
For businesses considering entity-level taxation, consulting with experienced tax professionals is crucial. This strategy’s potential benefits can be substantial, but it must be implemented thoughtfully and in alignment with the business’s overall tax planning goals.
If you think entity-level taxation may be beneficial for you, we have a highly qualified team of professionals who can help you move forward. Contact us to learn more.