Complexities Abound for Pass-Through Entities and SALT Deduction Work-Arounds

by Gregory M. Rineberg, CPA, and James J. Newhard, CPA | Mar 01, 2021

The Tax Cuts and Jobs Act of 2017 (TCJA) reformed many aspects of the Internal Revenue Code of 1986, but the $10,000 state and local tax deduction limitation (SALT cap) has remained one of its more controversial aspects. The SALT cap prevents many individuals from being able to fully deduct their state and local income and property taxes on their federal individual income tax returns.1 This is further exacerbated for individuals filing in multiple states through their ownership interests in partnerships, S corporations, and certain limited liability companies.

To mitigate the impact of the SALT cap, states have experimented with work-arounds that allow the deduction of additional state taxes on federal returns. Several created government-sponsored charities to convert limited state tax deductions to charitable contribution deductions. However, the IRS published regulations expressly denying this work-around.2 Other efforts likewise did not appear to be effective, except for a pass-through-entity-level tax (PTE tax). Pass-through entities can be a partnership, an S corporation, or a limited liability company treated as a partnership for federal income tax purposes. The PTE tax is not a privilege tax or a franchise tax that the pass-through entity pays, but rather an income tax. Contrary to other types of entity-level taxes, this is an entity-level income tax with a credit for owners to claim on their respective state individual income tax returns.3 Currently, seven states either require or allow pass-through entities to pay PTE taxes on behalf of their owners (Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island, and Wisconsin), and more are looking to enact similar PTE taxes.4

On Nov. 9, 2020, the IRS released guidance agreeing that pass-through entities may claim a federal tax deduction for PTE taxes paid (IRS Notice 2020-75). Although the IRS approved the PTE tax as a SALT cap work-around and there are a number of states that have some variation of the PTE tax, questions remain. One of the biggest is whether the Biden administration will eliminate or increase the SALT cap, and whether any changes would be retroactive. This feature addresses the tax and financial statement accounting treatment of PTE taxes under current law and U.S. generally accepted accounting principles (GAAP), with an income tax focus on states geographically close to Pennsylvania, such as Connecticut, Maryland, and New Jersey.


State PTE Taxes

Connecticut – Effective for tax years beginning on or after Jan. 1, 2018, Connecticut mandates pass-through entities to pay tax on behalf of its owners.5 If a pass-through entity has Connecticut-sourced income, then it is required to pay tax on each owner’s share of their income at a rate of 6.99% when the pass-through entity files its Connecticut Pass-Through Entity Tax Return (Form CT-1065/CT-1120SI). Although the pass-through entity pays tax at a rate of 6.99% on its owners’ behalf, the owners don’t receive the full credit for the tax paid. Each owner receives an offsetting credit based on the percentage of the owner’s direct and indirect share of the PTE tax, which is shown on the Connecticut K-1. For the 2018 tax year, the credit percentage was 93.01%, and thereafter the credit percentage is 87.5%. 

Maryland – Effective for tax years beginning after Dec. 31, 2019, Maryland allows pass-through entities to elect to pay tax on behalf of its resident owners at the entity-level.6 The election must be made annually by the pass-through entity on its Maryland Pass-Through Entity Income Tax Return (Form MD 510).7 Although Maryland has historically required pass-through entities to pay tax on nonresident owners’ distributive or pro rata shares of income allocable to Maryland, the pass-through entity now has the ability to pay its resident owners’ portion at a rate of 8% (state rate of 5.75% plus local county rate of 2.25%). Owners would receive a credit on their Maryland K-1s equal to the amount of taxes paid by the pass-through entity and claim the credit on their respective Maryland individual tax returns. Maryland does not consider the PTE tax to be paid on behalf of the owners, but rather a tax paid by the entity. Since the tax is paid by the entity, it could be difficult for owners to claim credits for PTE taxes paid to Maryland. It is expected that Maryland will provide clarifying guidance in the form of updated regulations.

New Jersey – Effective for tax years beginning on or after Jan. 1, 2020, New Jersey allows pass-through entities to elect to pay tax on behalf of its owners.8 Rather than adding on the PTE tax to existing tax laws and forms, New Jersey created the Business Alternative Income Tax (BAIT). The annual election to file and pay the BAIT must be made prior to the original due date of the pass-through entity return and requires the consent of all owners or any person authorized to act on behalf of the entity. Additionally, at least one owner must be subject to the New Jersey gross income tax on their share of distributive proceeds. If the pass-through entity elects to participate, it must file New Jersey Form PTE-100 and pay the tax due on each owner’s distributive share of proceeds at the entity level. The BAIT is imposed at a graduated rate commensurate with state taxable income, ranging from 5.675% to 10.9%. Each owner receives a credit on their NJ K-1 to claim against their gross income tax liability on their respective New Jersey tax returns.

Other states – Louisiana, Oklahoma, Rhode Island, and Wisconsin have enacted similar PTE taxes. While their administrative process may be different in terms of making an election and claiming credits on tax returns, the goal is the same: the pass-through entity would pay each owner’s tax at the entity level as a work-around to the SALT cap. Currently, though, Connecticut is the only state that mandates pass-through entities to pay income taxes on behalf of their owners at the entity level.9

Income Tax Considerations 

Federal tax benefit – There is a potentially significant federal tax benefit for pass-through entities that participate in states’ PTE taxes since PTE taxes are currently expected to be fully deductible for federal income tax purposes. For example, assume each of Partnership A’s partners owe tax of $100,000 to New Jersey based upon their pro rata share of the pass-through entity’s New Jersey gross distributable income, and that each partner is already limited by the SALT cap due to other taxes. Prior to the BAIT program, these partners would have a federal tax detriment of roughly $37,000 ($100,000 x 37% statutory rate). By electing to participate in the BAIT program, each partner would receive a federal tax benefit of $37,000 as a result of the pass-through entity being able to fully deduct $100,000 as a business expense.10

Resident credits – A resident is taxed on all of his or her income in the resident state. Because he or she may also be taxed on the same income in nonresident states, a credit for taxes paid to nonresident states may be allowed. However, if a pass-through entity pays the individual’s tax at the entity level, it is not clear if the resident would receive a nonresident credit for taxes paid to other states. The crux of the matter is whether states look upon a pass-through entity as separate and apart from its owners or as an aggregation of its owners. Under the aggregate theory, a state should allow a nonresident individual credit for taxes paid to another state by the pass-through entity since pass-through entities are nothing more than the sum of its parts. However, there are states that consider pass-through entities as standalone entities, and any income tax paid by the entity should not be considered as a nonresident credit available to residents. Maryland’s guidance, for example, states that the PTE tax is an entity tax and not paid on behalf of owners. Pennsylvania only permits resident owners of an S corporation a nonresident credit for taxes paid to other states by a pass-through entity.11 The credit is currently not available for resident owners of a partnership.12 Thus, while a Pennsylvania resident shareholder can claim a nonresident credit for taxes paid by the pass-through entity, a Pennsylvania resident partner cannot. However, the Pennsylvania Department of Revenue has indicated there is the possibility that Pennsylvania would not allow a credit to shareholders since the New Jersey BAIT is an entity-level tax. Conversations regarding this position are ongoing. Each state has different rules regarding if and how an owner can claim a credit for income taxes paid to other states. 

Owners not subject to tax – It can be common for pass-through entities to have owners who are not subject to income tax. These owners could be tax-exempt, foreign, or simply have incurred a loss for federal income taxes in a given year. Generally, these owners should not have tax paid on their behalf by the pass-through entity. However, a consequence of electing to participate in a states’ PTE tax could result in the pass-through entity overpaying taxes on behalf of owners who are not liable. This is primarily due to the fact that the PTE tax includes all owners. Assuming that an entity elects to participate in the PTE tax and remits tax for owners who are not subject to income tax, then those owners should be entitled to a refund. For example, if a pass-through entity with tax-exempt owners elects to pay the New Jersey BAIT, then those tax-exempt owners should be able to claim a refund for the amount of tax paid by the pass-through entity.13 Currently, there is a not a prescribed refund form.

Accounting for PTE taxes – For accrued expenses, such as PTE taxes, to be deductible for federal income tax purposes, they must pass the all-events test. The test is satisfied when all events have occurred that determine the fact of liability and the amount of such liability can be determined with reasonable accuracy.14 Therefore, unless a pass-through entity filed its election prior to Dec. 31, 2020, to participate in a state’s PTE tax and estimated the tax liability, then it would not be able to claim those PTE taxes as a deduction on the 2020 federal tax return. Elections are required to be made annually before the end of the tax year if the pass-through entity wants to deduct its PTE taxes from the federal return. Specifically, the due date for an election in many of the states’ regimes is not until the partnership’s filing due date. This applies for the 2020 tax year as well as future tax years. 

U.S. GAAP Financial Reporting

The Accounting Standards Codification (ASC), specifically ASC 740, Income Taxes, provides the guidance for companies to account for and report the effects of taxes based on income, and applies to federal, state, local, and foreign income taxes. Current federal tax law does not assess a general income tax on ordinary taxable income of pass-through entities, and prior to the TCJA neither did states. From a GAAP reporting basis, pass-through entities generally have had no income taxes applied at the entity level, with the income taxed at the proportionate share to the owner level. Accordingly, financial statement income tax disclosures are principally qualitative, limited to indicating the following:

• Income taxes are the responsibility of the equity investors.
• No income tax expense or benefit has been recorded.
• The company evaluates tax positions that would have a material effect on the financial statements.

• There are specified tax years that remain subject to examination by the IRS, states, or local taxing jurisdictions.

States that enacted entity-level income taxes on pass-through entities may allow some credit, deduction, or exclusion to the owners as a work-around to the SALT cap via specified income tax payments. A specified income tax payment is not an item of deduction that a partner or shareholder takes into account separately in determining its own federal income tax liability, and is not taken into account in applying the SALT deduction to any individual partner or shareholder. Accordingly, pass-through-entity financial statements will be required to apply ASC 740 to a measure, recognition, and presentation level, as well as an expanded disclosure requirement. Connecticut, Maryland, and New Jersey are relative neighbors of Pennsylvania and could have an impact on business entities for whom Pennsylvania CPAs provide services.

The ASC 740 objectives are as follows:
• Recognize the amount of taxes payable/refundable for the current year.
• Recognize deferred tax assets and liabilities for future tax benefits/consequences of events that have been recognized in an entity’s financial statements.

• Convey the disclosures of the tax characteristics of the entity, its operations, its tax positions, its legal obligations, and off-balance-sheet items of carryover/carryback (including limitations and expirations), management’s assessment of realization of future benefits (including valuation allowances), and other tax policies and/or elections with direct or indirect income tax implications or consequences.

ASU 2019-12, Simplifying the Accounting for Income Taxes, clarifies the necessity to bifurcate a tax assessed by a taxing jurisdiction levying a combined/alternative calculated tax determined by components that include a calculation based on income, irrespective of whether the other components calculated are franchise, value, gross receipts, or some other means of measurement. Accordingly, to the extent that the jurisdiction’s levied tax equals or exceeds the amount calculated on net income, that portion must be recognized and characterized as income tax, and any remaining excess amount shall be charged as other operating tax expense.

ASC 740 will require maintaining and tracking, by state and local taxing jurisdiction, the allocated, apportioned, and attributed items of position, income, expense, gain, and loss from those items constituting temporary differences (the difference caused by GAAP tax recognition policies as compared to the tax accounting recognition applied to and dictated by the applicable taxing authority). These differences will necessitate provisions for deferred tax assets and/or liabilities, along with expanded disclosures of carryover/carryback amounts and tax positions.

GAAP tax positions – In the context of GAAP, a tax position is a stance taken in a tax return that measures assets and liabilities that result in either a permanent or temporary deferral of income taxes, which includes current and previous returns, as well as returns “elected” not to be filed. Uncertain tax positions that may not be sustainable upon examination by taxing authorities – based on a required presumption that any and all tax positions on the return will be examined, regardless of the likelihood that this will actually occur – must be assessed and quantified, and a provision (liability) recognized to the extent a tax benefit would not meet a more likely than not (greater than 50%) threshold of being sustained upon examination. Further, provisions of both applicable penalty and interest must be recognized, either included with the tax provided or classified separately, applied consistently, and disclosed as an accounting policy. Generally, these provisions are classified as noncurrent liabilities, and may not be combined or netted with income tax liabilities on the balance sheet.15

Except for tax positions that never expire, the liability for uncertain tax positions will ultimately reverse when the statute of limitations expires or the position is examined and no longer “uncertain,” even if disallowed.

ASC 740 requires the following disclosures for income taxes:

• Grossed-up amounts of deferred tax assets and liabilities netted on the balance sheet, including any valuation allowances
• The components of income tax expense related to continuing operations each year
• The types of temporary differences and carryforwards
• Reconciliation of taxes provided on continuing operations (private companies need only disclose the nature of these items)
• The amounts and expirations for operating losses or credits carried forward
• Any position of the valuation allowance for which subsequent benefits allocated reduce goodwill or intangible assets from an acquisition, or contributed capital
• Intraperiod tax allocations
• Specialized situations disclosures

• Classification policy for penalty and interest 


It’s important to note that electing to participate in PTE taxes may not be the best approach for all pass-through entities. A cost-benefit analysis should be conducted to determine if it makes business sense to elect to participate in a PTE tax, where not mandatory. The reality is that each state’s PTE tax is different from the other. Due to administrative burdens, such as electing to participate, potential credit and refund issues, and a lack of state guidance on how to properly account for PTE taxes from an ASC 740 perspective, PTE taxes may create compliance complexity and costs in both the PTE tax states, the resident states, and with accounting and capital account maintenance. Other taxpayers may want to do tax planning by setting up pass-through entities specifically to take advantage of the federal deduction. Practitioners should continue to closely monitor federal and state guidance, as well as the potential expansion of PTE taxes to other states.  

1 Individuals in nonincome tax states may deduct sales taxes in lieu of income taxes.

2 Contributions in Exchange for State or Local Tax Credits, 84 Fed. Reg. 27513 (June 13, 2019).

3 “Owners” is used to include all individuals or entities that are partners, shareholders, or members in a partnership or S corporation.

4 Currently, California, Illinois, and New York have introduced draft legislation to create a PTE tax.

5 Matthew DiDonato, Arthur Burkard, and Rob Michaelis, “SALT Alert: Connecticut Legislation Responds to Federal Tax Reform,” Grant Thornton LLP (June 19, 2018).

6 Joel Waterfield, Guinevere Seaward Shore, and Jarryd Ritter, “SALT Alert: Multiple Maryland Tax Bills Enacted,” Grant Thornton LLP (June 11, 2020).

7 Comptroller of Maryland, Md. Income Tax Admin. Release No. 6, Taxation of Pass-Through Entities (2020).

8 Matthew DiDonato, Bridget McCann, and Drew VandenBrul, “SALT Alert: New Jersey Enacts Elective Alternative Business Income Tax for Pass-Through Entities as Work-around to SALT Deduction Cap,” Grant Thornton LLP (Feb. 11, 2020).

9 The District of Columbia, New York, and Philadelphia have mandated PTEs pay income tax for owners at the entity level.

10 The assumption is that the partner would receive the full benefit of not having to limit any of the $100,000 state and local tax deductions on Form 1040 since it was paid by the PTE. Assumed highest federal tax rate for individuals in 2020. The federal variable relative to possible savings in self-employment tax and the offsetting potential loss of qualified business income deduction was not factored in.

11 72 Pa. Stat. Ann. Section 7314.

12 Pennsylvania Department of Revenue, FAQs: Credit for Entity Level Tax Paid by Pass-Through Entities (Answer ID 3618) (Jan. 31, 2019). 

13 N.J. Division of Taxation, Pass-Through Business Alternative Income Tax Act – FAQ (Dec. 23, 2020). 

14 IRC Section 461(h)(4) (2020).

15 ASU 2013-11 does permit the netting of the tax-portion of the liability against deferred tax assets to the extent they relate to net operating loss or credit carryforwards.

Gregory M. Rineberg, CPA, is a state and local tax manager with Grant Thornton LLP in Philadelphia. He can be reached at

James J. Newhard, CPA, is a sole practitioner in Paoli, a CPE presenter for Kaplan Financial Education, and a past-president of PICPA’s Greater Philadelphia Chapter. He serves on numerous PICPA state and chapter technical committees, is a member of the Pennsylvania CPA Journal Editorial Board, and serves on the AICPA PEEC committee. He can be reached at

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