SALT deduction parity

Historically, individuals have been able to deduct income, property and certain other state and local taxes as an itemized deduction on individual federal income tax returns — referred to as the state and local tax (SALT) deduction. For example, an individual making $200,000 might pay around $10,000 in state income tax and another $5,000 in property tax, for a total SALT deduction of $15,000.

In 2017, the Tax Cuts and Jobs Act imposed a $10,000 cap on the amount an individual may deduct for federal tax purposes for the payment of state and local taxes. Although the cap impacted citizens in all states, it was particularly painful in states with high state and local income taxes because the limitation on the itemized deduction caused an increase to taxable income.

Fast forward to 2021 and the Arkansas legislative session. Act 362 of 2021 created a voluntary tax that pass-through entities can pay if owners of more than 50% of the voting rights of a pass-through entity elect to do so. Income of a member that is subject to the pass-through entity tax (PTE) would be excluded from Arkansas income tax on the personal income tax returns of the owners. Arkansas joined approximately half of the states with a state income tax in enacting a PTE tax.

Electing into the PTE results in the Arkansas tax liability being paid at the entity level at a flat rate of 5.5%. The entity accounts for this expense in calculating its income, and the deduction reduces net income reported to the IRS and to partners or shareholders of that entity. For federal income tax purposes, the income will continue to flow through to the partners. But, for Arkansas income tax purposes, that income will be excluded from tax so that there is no double taxation.

The entity has to complete and file form AR362 to make the PTE election, and a responsible party is required to sign the form certifying that the members holding more than 50% of the voting rights have approved. The election must be made annually on or before the due date or the extended due date of the business entity’s income tax return.

The PTE tax must be paid in quarterly installments to avoid underpayment penalties; however, estimated tax payments will not be required in 2022 because it is a new tax. Estimated payments will be required in 2023. The PTE tax will be subject to the interest and penalty provisions of the Arkansas Tax Procedure Act.

The benefit of making a PTE election is that the entity pays the Arkansas state income taxes due rather than the partners or shareholders who could otherwise be limited on the SALT deduction on their personal returns. Because this SALT cap does not apply to entities, this election is effectively a workaround for the $10,000 SALT cap.

Is the PTE tax right for you or your entity? Not all situations are the same, but the potential benefits are worth your consideration.

Jake Fair is a partner and certified public accountant with Wright Lindsey Jennings. The opinions expressed are those of the author.