Earlier this year, the Kentucky legislature passed HB 5 allowing pass-through entities to file an election to pay state taxes at the entity level instead of the personal level. The concept is to give business owners some relief at the federal level by allowing them to deduct state taxes on their business income as an expense and lower their federal tax liability. It is an election that will need to be filed annually and once it is made it is irrevocable and binding on all entity owners. This legislation will take effect beginning on January 1, 2022, so it is retroactive.
A pass-through entity, as a refresher, is any entity in which the income of the business is “passed on” to the owners of the business and reported on their personal return. This is pretty much any business that’s not a C-Corporation. The election is, however, not allowed for Trusts, although a non-Trust entity that has a Trust as a shareholder can still make the election, pass the credit onto the Trust and any remaining credit can be taken by the beneficiaries of the Trust. I thought that was kind of cool, even if it reads like tax code soup.
So, what is the benefit? Prior to 2018, these taxes would be deductible on a business owners personal return as an itemized deduction, but since the Tax Cuts and Jobs Act put a $10,000 cap on the state and local taxes that you can deduct (also known as the SALT cap), it makes the deduction of those taxes almost impossible. But if the taxes are deductible at the entity level, then that lowers the taxable income of the business and therefore the federal taxes. That all sounds great, but you should still consult with a tax specialist before making the election. Some people may actually itemize and deducting the state taxes at the entity level may cause you not to be able to itemize deductions on your personal return. Lowering the business income also lowers the deduction for Qualified Business Income, so you will need to determine if the deduction of the state taxes is worth the loss of the QBI deduction. It is all a very complex balancing act that you will need a tax professional to navigate.
The new legislation comes with a new series of paperwork. If you wish to make the election, you will need to file it annually by completing form 740-PTET. After January 1, 2023, the election will need to be made by the 15th day of the fourth month after the close of the taxable year. Estimated tax payments will need to be made using form 740-PTET-ES so that the payments will be made at the entity level and not the personal tax level. The Department of Revenue cannot simply move the tax payments from your personal taxes and apply them to the business return. Basically, even if you don’t make the election until the following year, if you and your tax professional determine that making the election is what’s best for your tax situation, then you will want to make the tax payments as if the election to pay the state taxes at the entity level has already been made. Otherwise, you will have to pay the taxes to the state again through the business and wait for a refund for the estimated tax payments made for your personal return.
The legislation is retroactive, which is every tax preparer’s favorite kind of legislation and seems to be the only kind that Kentucky is passing these days. Luckily, the legislature is giving taxpayers plenty of time to work with their tax professionals to see if this is the best course of action for them and their business. Businesses have until August 31, 2024 to make the election for the tax year ending 2022. You will then need to amend your personal and business return showing that the election was made, and the taxes were deducted at the personal level. This will affect any business partners as well, so you will want to confirm with all owners of the business that this is what is best for their tax situation as well.
To clarify, this is just for Kentucky business owners. There are some other states that allow for pass through taxes to be deducted at the entity level, but not all states have something like this in effect. For most business owners this will provide a benefit, but you will still want to check with a tax professional to make sure that it is the best approach and that the appropriate paperwork is filed. It may also be advantageous making the election for 2022 and filing amended returns, however there may be up-front costs such as paying a tax professional to amend the returns and paying the taxes at the entity level, then you will have to wait for the Department of Revenue to send a refund for your personal taxes. Due to the large amount of anticipated amended returns, taxpayers are being warned that there may be a delay in their refund.
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