On November 18, 2021 North Carolina governor Signed Senate bill 105 which includes a new elective Pass–Through Entity Tax (“PTET”). This law, first effective in 2022, has the potential to save federal income taxes by making NC income taxes on pass-through entities (“PTEs”) income deductible when they may have not been in the past. This is a so called state and local income tax (“SALT”) Cap workaround. Eligible PTEs defined as S-Corporations, and certain Partnerships may make this election. Partnerships excluded from making this election are those with partners that are corporations, other partnerships, and certain trusts.
How It Works
Currently, state and local income taxes paid are capped at $10,000 on schedule A of form 1040. These taxes include real estate, personal property (ad volorem), and state & local income taxes. Many high-income taxpayers and those with large real estate tax bills are capped at $10,000 on their personal income tax return. So for those eligible PTEs that make this election, the NC tax would be paid at the entity level and deducted from the PTE’s income that is reported to the shareholders or partners on their K1s.
Example
NC S-Corporation with one shareholder and $500,000 of income: The shareholder is in the maximum federal income tax bracket of 37%. The S-Corporation makes the PTET election and pays the NC tax at the entity level of $24,950 (4.99% in 2022). We will assume the shareholder has in excess of $10,000 in SALT on their personal tax return due to real estate taxes and state withholding on wages. The NC Tax paid by the PTE of $24,950 now becomes deductible on the S-Corporation tax return, and the federal tax savings are $9,231 at the 37% federal tax rate. Normally, this $24,950 would not be deductible as the shareholder had already reached the SALT Cap on their personal tax return.
Important Takeaways
IRS Notice 2020-75, clarifying the deductibility of SALT payments at the entity level, states that the PTET must be “paid” during the taxable year to be deductible. Thus, estimated tax payments should be made by the electing PTE in 2022 to ensure their deductibility. Additionally, if the shareholder or partner would normally make NC estimated tax payments personally, they may need to be re-evaluated and adjusted or discontinued to avoid overpaying NC.
Our team at Dreher Martin CPAs will continue to review the guidance from NC as it is released and will post updates as they become available. If you have any questions in the interim, please reach out to one of our team members.