Payroll tax, federal income tax, state income tax, property tax, sales tax, gas tax…. you get the idea; we pay a lot of taxes. So why all the excitement surrounding Minnesota’s new pass-through entity (PTE) tax? In short, the PTE tax actually has the potential to save taxpayers money. At first glance, this doesn’t seem to make sense; how does paying small business taxes save you money? There are, however, scenarios where this is the case. Below is a closer look as to how.
Traditionally, taxpayers have been able to deduct their state income tax payments as an itemized deduction on Schedule A of their Federal tax return. For high income taxpayers living in a state with a high state income tax rate (such as Minnesota), this could result in a significant reduction of federal tax liability. This all changed with the passing of the Tax Cuts and Jobs Act (TCJA) in 2018. The TCJA now limits the federal deduction for the combination of property and state income taxes to $10,000. Any combination of property and state income taxes paid over this threshold provides no federal tax benefit.
The IRS in 2020 issued guidance that allows willing state tax authorities a work-around to this problem for business owners of passthrough entities. Instead of a passthrough entity (S-Corporation or Partnership) reporting business income and then eventually paying the state income tax at the individual level, a passthrough entity with Minnesota sourced income can elect to pay the state income tax itself, called the PTE tax. This results in the Minnesota business deducting the state income taxes paid at the federal level and, consequently, lowering the federal taxable income passed through to the individual taxpayer. The individual taxpayer then gets a Minnesota state tax credit for the amount paid by the business. The state income tax remains the same; the difference only lies in who pays it (the taxpayer or the taxpayer’s passthrough entity). Below is an example to demonstrate how this would work:
Let’s assume Tim is the sole shareholder of an S-Corporation that had $300,000 of taxable income during 2021. Tim also has $20,000 of itemized deductions not including state income tax. (For simplicity’s sake, progressive tax rates are ignored in the example.)
No PTE tax paid by S-Corporation: Tim’s Minnesota state tax liability would be $29,550 ($300,000 x 9.85%). His federal taxable income would be $270,000 ($300,000 — $20,000 of itemized deductions — state income taxes capped at $10,000). His federal tax liability would be $64,800 ($270,000 x 24%).
PTE tax paid by S-Corporation: Tim’s S-Corporation pays and deducts a $29,550 Minnesota PTE tax ($300,000 x 9.85%). This results in federal taxable income of $245,350 ($300,000 – $29,550 – standard deduction of $25,100) and a lower federal tax liability of $58,884 ($245,350 x 24%). Tim’s Minnesota tax liability would still be $29,550 ($300,000 x 9.85%), none of which he would personally need to pay because his S-Corporation already paid it on his behalf.
From the example above, you can see that the PTE tax saved our taxpayer, Tim, $5,916 of federal tax. If you are a high-income taxpayer that is affected by the $10,000 state income tax deduction limit, the Minnesota PTE tax election could benefit you as well. It’s important to note, however, that the PTE tax is only one of many tax savings strategies that should be considered if your passthrough entity business has disposable money. Contributing to a retirement plan, for example, is another tax savings strategy to consider.
Talk to your Mahoney tax advisor, Craig Mulcahy, to determine if you can utilize this new Minnesota PTE tax election for your pass-through or small business.
Looking for other ways to save money on your business income tax? See which tax strategies work for you, in these related blogs.