As you are probably aware, the Federal tax code was amended in 2017 to limit the deduction that individuals can take for state and local taxes to $10,000.
As noted in prior installments of Did You Know, both Minnesota and Indiana have adopted laws that enable owners to avoid that limitation by having their partnership or S corporation pay the income tax on the company’s income (rather than the owners pay it on their share of the income). As a result, the company can deduct the full amount of the state income tax for federal tax purposes and the owners get a credit against their state tax liability. The IRS has effectively blessed these structures in Notice 2020-75.
As of now, 36 states (and New York City) have adopted some form of PTE tax. Most state legislation is effective in 2022, but several states have made their PTE tax retroactive. For instance, Nebraska’s new PTE tax is retroactive to 2018. While taxpayers can only amend their federal income tax returns going back three years from when it was filed, Nebraska’s law does not require prior returns to be amended, but allows prior year taxes to be paid in 2023, 2024 or 2025. This results in a current deduction against federal income taxes and the taxpayer gets a refundable state income tax credit for the prior years.
It is important to remember that these PTE tax rules vary from state to state. In a multi-state partnership, some members may benefit while the opposite is true for others. For example, a nonresident member may not be able to get a state tax credit in their resident state for taxes paid by the PTE thereby resulting in a higher state tax cost for them.
Bottom Line: In structuring a purchase or sale of a business, the potential to deduct the state income tax on the gain or the ability of a seller to deduct state taxes paid in prior years could be a substantial benefit to both the buyer and the seller, but beware of collateral consequences.
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