(UPDATED 1/8/2021 – see in red below)
Attention pass-through entities: IRS provides guidance allowing a deduction for a pass-through entity tax assessed by a state.
Many states enacted a tax provision to impose either a mandatory or elective entity-level income tax on pass-through entities generating business in the state. Besides imposing the entity level tax, the provision may allow a corresponding owner-level tax benefit in the form of a state tax credit, deduction or exclusion. The state provision was enacted as a work around to the state and local income tax deduction limitation of $10,000 for individuals.
The entity level tax paid, even if voluntarily, by a pass-through entity is treated as an ordinary and necessary business expense, reducing the taxable income of the partnership or S Corporation. It need not be separately stated on the Schedule K-1 for the owner to consider in the state and local income tax deduction. Even though the owner may have a state income tax credit to offset the personal income tax liability, the deduction is still allowed.
Many states define pass-through entities differently. Rhode Island allows partnerships, S corporations, trusts, and sole proprietors to elect to pay an entity level tax of 5.99% of net income. The election is an annual election. If the election is made, the partnership and S corporation will not be required to withhold on non-resident owners. Any entity level tax paid is allowed as a credit against the Rhode Island income tax. There is a RI modification increasing the Rhode Island source income.
Net income includes ordinary income, net rental income, and guaranteed payments reduced by Section 179. Net income doesn’t include investment income.
The election is made by the entity by filing Form BUS-EST and remitting the appropriate state income tax.
The state entity level tax is paid through estimated tax payments due quarterly on April 15, June 15, September 15 and December 15 for a calendar year. The balance of the tax is paid by filing Form RI-PTE on March 15 after the close of the tax year.
Any underpayment of the entity level tax is subject to an 18% underpayment penalty so this is a problem for those who elect now for 2020 and who have not paid the quarterly estimates (UPDATED BELOW IN RED). The Rhode Island Division of Taxation provided penalty relief for late payment of the 2019 estimated tax payments and relief is being asked for 2020 due to the uncertainty surrounding the federal deduction of the entity level tax and the recent IRS guidance settling the uncertainty.
Posted on 1/6/2021, the Rhode Island Division of Taxation will not assess underestimated payment interest for those entities that make the PTE election for the first time in the 2020 tax year and have not made estimated payments throughout the 2020 tax year. However, if a taxpayer made the election in 2019 and 2020 and failed to make sufficient estimated payments in 2020, that taxpayer would be subject to the 18% underpayment penalty.
We will provide additional information once there is a decision by the Rhode Island Division of Taxation relative to a penalty waiver.
The IRS guidance doesn’t cover the deductibility of the tax for a trust or a sole proprietor.
Please contact us if you would like to discuss how this new guidance can help you save federal income taxes.