Angélica Serrano Román

This article was originally published in Bloomberg Tax.

With Congress still undecided about the future of the 2017 tax law’s cap on state and local deductions, states continue to tinker with the workarounds they’ve created to give some of their residents a measure of relief.

Nearly two dozen state legislatures considered bills this year creating or modifying pass-through entity taxes, which became widespread after the imposition of the $10,000 federal limit on personal deductions for state and local taxes.

Since the cap was introduced, 36 states and New York City have implemented various forms of pass-through entity taxes. These provisions allow partnerships and similar businesses to pay state income tax at the entity level, instead of passing income through to individual owners, who receive a state tax credit offsetting the federal deduction limit.

Seven states—Hawaii, Iowa, Indiana, Kentucky, Montana, Nebraska, and West Virginia—created PTET regimes in 2023, while legislatures in Maine, Pennsylvania, and Vermont explored it but didn’t get to enactment. And still more tweaked their laws as the scheduled December 2025 sunset of the SALT deduction ceiling draws nearer.

The most significant change came in Connecticut, which adopted legislation (HB 6941) shifting its tax from mandatory to optional starting in 2024, bringing it in line with other states in that respect. It’s a major update for Connecticut’s pass-through entity tax, which was the first to be enacted after the 2017 law’s passage.

Tony Konkol, state and local tax manager at accounting firm Cherry Bekaert, said Connecticut’s modifications came after years of observing and evaluating how other states administered their pass-through entity taxes.

“With Connecticut making this change, it kind of reflects the themes in a lot of the legislation this year, which I think is the emphasis on flexibility and giving more opportunities for entities to make these elections,” Konkol said.

Patrick Skeehan, a senior manager in state and local tax at Grant Thornton LLP, said Connecticut’s mandatory election could have led to “cash flow management” situations. In a hypothetical scenario, where a pass-through entity sells assets and distributes all the proceeds to its owners, there might not be enough cash on hand to cover the tax liability when it becomes due.

“Under an elective regime, you’re less likely to have cash flow management issues, especially for years in which entities know that they are going to have an event that could lead them to be short on cash and fund the tax liability,” Skeehan added.

Other changes Connecticut enacted for 2024 altered the method for calculating the pass-through tax base, eliminated the corporation tax credit for pass-through entity taxes paid, and removed the option for pass-through entities to file a combined return with one or more commonly owned entities.

Fate of the SALT Cap

Other states focused on extending expiration dates for certain provisions of their pass-through entity taxes, easing ownership requirements, expanding eligibility for the workaround, or making the credit refundable.

Hanging over all of it is the unknown: whether Congress will extend or alter the SALT cap beyond 2025. But whether lawmakers decide to raise the cap or eliminate it entirely, states may keep their PTET policies in place, said Eileen Sherr, director of tax policy and advocacy at the Association of International Certified Professional Accountants.

“I think the states are probably going to end up keeping these pass-through entity taxes regardless,” she said. “Some states already scheduled to go that far, until the federal expiration date, and some are already scheduled to go beyond that.”

Should the cap expire, Skeehan said states that implemented pass-through taxes linked to the federal limit might have less appetite for renewal.

“I think in some cases, that would make the appeal and value of making PTET elections in those states less attractive, but there are certainly still arguments to be made for the benefits of these types of regimes beyond just the workaround, but for example, owners that may be subject to the alternative minimum tax,” Skeehan said.

Expansions, Refundable Credits

Beyond Connecticut, many other states are implementing changes to their pass-through entity taxes. Georgia, North Carolina, and Virginia all passed legislation that repealed a limitation on the types of partnerships that may elect to pay income taxes at the entity level.

In North Carolina, lawmakers also passed SB 174, extending S corporation owners’ eligibility and clarifying the tax calculation process. In Virginia, HB 1456 modified the existing statute by replacing “qualifying pass-through entity” with “eligible owner.” Previously, partnerships with corporate partners were ineligible to make the election. The commonwealth now allows such partnerships to make the election but restricts the tax to the income of individuals, estates, and trusts.

Ohio now allows residents facing double taxation to use a long-standing resident credit for PTET payments to other states, starting from tax years beginning on or after January 2022, under a law (HB 33) Gov. Mike DeWine (R) signed in July. However, PTET investors must “add back” certain pass-through taxes imposed by another state that the investor deducts from federal adjusted gross income as a business expense.

Additionally, Oregon extended its PTET election through 2025 with the passage of HB 2083, keeping it in place through the remaining period of the federal cap.

Messing With Projections

While pass-through entity taxes are designed to be revenue-neutral over time, they have created confusion for some states when making accurate revenue projections.

Virginia Finance Secretary Stephen Cummings said earlier this year that the commonwealth encountered issues as some individuals only partially utilized the new tax structure. Individuals either didn’t fully adjust their non-withholding payments or made no changes to reflect their reduced tax liabilities, resulting in a situation he called “a significant mess” that left Virginia with about $1 billion more in revenue than projected initially.

New York State Comptroller Thomas DiNapoli released a report in July showing some effects of the tax, which state leaders and businesses were still navigating. Personal income taxes have historically been New York’s largest source of tax revenue, constituting 62% of total tax collections over the past decade. This share has decreased to just over half of tax revenue since the introduction of the PTET. While the tax’s long-term impact is expected to be revenue-neutral, that may not hold true from one fiscal year to the next, especially when taxpayers claim offsetting individual tax credits, DiNapoli said at the time.

Shareholders and partners can typically claim a credit on their personal tax returns equivalent to 100% of the distributive share of pass-through entity tax paid by the member. A bill (SB 1980/AB 3690) aimed at reducing New York’s PTET credit from 100% to 75% didn’t advance this year.

While pass-through entity taxes are on the books in most states, practitioners say they are still waiting for more IRS guidance on the workarounds. The agency last released guidance regarding PTET elections in 2020, when it generally approved the SALT cap workaround strategy but also announced “forthcoming” proposed regulations to provide clarity on details of “specified income tax payments” that are deductible. Tax practitioners are looking for the agency to address such other concerns as what constitutes a paid tax and details related to mixed pass-through entities.

“The IRS has not provided much guidance on PTETs, they just did that one notice,” Sherr said. “We’ve sent in several sets of comments, asking for some particular guidance from IRS about what to do with these, but they haven’t.”

Photo: Daniel Acker/Bloomberg