The GAAP in Accounting for PTE Taxes

The GAAP in Accounting for PTE Taxes

by James J. Newhard, CPA | Dec 09, 2022

By James J. Newhard, CPA 


pa-cpa-journal-the-gaap-in-accounting-for-pte-taxesIn Pennsylvania, the most used entity formation structure (excluding the sole proprietor schedule C) is the pass-through entity (PTE). Though PTEs also include trusts, the focus in this column is on partnerships and S corporations (which include limited liability companies that elect either partnership or S corporation tax reporting structure). Historically, these entities have not been subject to income tax at the entity level, but rather they pass the reported tax attributes of income, deduction, gains, losses, and credits to the partners, shareholders, or members (owners). Accordingly, U.S. GAAP financial reporting seldom had ASC-740 income tax disclosure matters.  

This has since changed in complex ways. CPAs specializing in A&A must now hold a lot more tax knowledge so they can truly understand the measurement, reporting, and disclosure necessities of today’s PTEs. Two distinct tax developments have created a challenge, perhaps exacerbated by ASU 2009-06. 


PTEs Withholding State Tax 

States usually tax residents on worldwide income, while generally taxing nonresidents on income/distributions from in-state sources. Generally, this creates a reporting and filing responsibility for the PTE owner who is a nonresident of the PTE’s reportable state. States have had difficulty ensuring that nonresident owners properly file and pay state income taxes on their proportionate shares of income. To increase compliance, many states began to require PTEs to either withhold and remit or make estimated payments on behalf of nonresident owners, which would be included on the owner’s state K-1 to be claimed as credit against the owner’s tax filing for that state.1 These state taxes are the responsibility of the PTE owners, with the PTE assigned the fiduciary responsibility of remitting on their behalf. Accordingly, these transactions would constitute equity-related transactions; the prevailing GAAP treatment would reference ASC 505, Equity, for disclosing distributions rather than ASC 740, Accounting for Income Taxes. Clarifying provisions are in ASU 2009-06, specifically 740-10-55-226. 

PTEs Assessed Income Tax

Subsequent to the federal itemized deductions limit on state and local taxes established by the 2017 Tax Cuts and Jobs Act (TCJA) and after numerous work-around attempts, there is a rapidly growing shift by states to establish an entity-level income tax on PTEs that would provide an income tax benefit against that state’s income tax liability imposed on the owners of the PTE. This PTE tax provides some credit against the owner’s individual state tax liability. 

The above-referenced guidance have clouded the treatment of PTE taxes. There are subtle nuances that, in this CPA’s professional assessment, would tip the scales toward ASC 740 treatment of PTE taxes. This is a business income tax that provides a credit to the owner’s state tax liability to mitigate double taxation by the same jurisdiction on the same income.  

Applying ASC 740 can get complex, especially if multiple states are involved. ASC 740 application requires not only accruals for state income taxes, but also accounting for deferred tax assets (DTAs) and deferred tax liabilities (DTLs). However, of the states involved (26 states have a PTE tax in 2022), many are annual elections and some are binding until unanimous revocation (Oklahoma). In Michigan, elections are irrevocable for three years, and in Virginia and Illinois there are legislative expirations in 2025 (aligned with the TCJA sunset, unless extended). While most states apply a flat rate tax, New York and New Jersey apply a rate scale (both with a top rate of 10.9%). Some states apply a different tax rate for the proportionate share applicable to a corporation. Rhode Island’s PTE tax election can also be made by sole proprietors. 

PTEs, however, do not contain provisions of loss carryback applications. Such possible carryback could only be potentially available to the owner at the owner’s tax-filing level, so refundable state income taxes are off the table. Timing differences would provide possible DTAs or DTLs. However, realization of a future entity-level benefit or consequence will be challenging in a principles-based manner, since elections are finite in application, future PTE tax treatment may be revoked, and impairment assessments will be challenging. Then there is the responsibility to apply accounting for tax positions and the related computed recognition. Each of these also needs to be addressed in the Income Taxes note to financial statements. 

ASC 740 vs. ASC 505

In the Section 55 implementation guidance and illustrations at paragraphs 226 through 228 in Topic 740 (examples of Attribution of Income Taxes to the Entity or Its Owners), a key driver of example 35 is that the PTE tax payment is “payment against the liability of the owners.” Withheld or estimated taxes for nonresidents are an exact personal income tax, dollar-for-dollar offset payments of the owners’ personal income tax (generally, not applicable to a corporate owner), making it an equity transaction on the owner’s behalf. Conversely, PTE taxes are a tax on business income. While most PTE tax rates are flat, 30 states have graduated individual tax rates. Thus, the PTE tax is not structured for a dollar-for-dollar offset. 

At this writing, the Private Company Council is assessing a request for more clarifying guidance because the concept of a PTE tax had never existed before 2018 and would never have been contemplated in the 2009 ASU. Hopefully, I’ll have more to report in the near future.   

1 Generally, most states provide residents a credit against income taxes for tax paid to another jurisdiction so as to minimize double taxation.  

James J. Newhard, CPA, is a sole practitioner in Paoli and a CPE presenter for Kaplan Financial Education. He serves on numerous PICPA technical A&A and tax committees and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at jim@jjncpa.com. 

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