On July 1, 2021, Governor Tim Walz signed into law Minnesota’s FY 2022-2023 State Budget, which includes a new elective pass-through entity (PTE) tax. This allows certain qualifying PTEs, including partnerships, limited liability companies (LLC’s), and S corporations, to elect to pay and deduct an entity level state tax.
PTEs as entities are exempt from income taxation. Instead, they “distribute” or report their income and other tax attributes to their owners who pay any resulting tax on their individual tax returns. Generally state income taxes are reported separately, and the owners are subject to itemized deduction rules, including the $10,000 limitation for state and local taxes under IRC section 164(b)(6). The IRS issued Notice 2020-75 on November 9, 2020 which announced its plan to propose regulations allowing optional PTE income taxes to reduce distributed PTE income treating the tax as a deductible expense and avoiding the itemized deduction rules.
The new Minnesota law appears to allow LLC’s to elect make the PTE entity election but IRS notice 2020-75 is based on tax code provisions that apply to partnerships and S corporations, so the state reference to LLC’s is most likely limited to the legal definition verses the tax definition. Forthcoming IRS regulations may permit the PTE election at a single member LLC level, but it is unlikely based on a review of the tax notice. Steps can be taken to ensure the PTE election is available by restructuring ownership of these entities.
Highlights of the new Minnesota passthrough entity tax election
– Effective for tax years beginning after December 31, 2020, a qualifying entity, including a partnership, limited liability company, or S corporation, can elect to pay an entity level tax in Minnesota.
– Qualifying entities do not include entities with a partnership, limited liability company other than a disregarded entity, or a corporation as a partner, member, or shareholder.
– The election must be made by the date the return is due or the extended due date and once made is irrevocable for that taxable year.
– The election may only be made by qualifying owners who collectively hold more than a 50% ownership interest in the PTE, and the election is binding on all qualifying owners.
– The PTE tax is the sum of the tax liability of each qualifying owner which is equal to the qualifying owner’s income sourced to Minnesota multiplied by the highest individual income tax rate of 9.85%.
– Qualifying owners generally include a resident or nonresident individual or estate that is a partner, member, or shareholder of a qualifying entity. A qualifying owner also includes a resident or nonresident trust that is a shareholder of a qualifying entity that is an S corporation.
– Electing PTEs are required to make quarterly estimated payments in the same manner as estimated payments are required for composite tax. Quarterly estimated tax payments are required if the sum of the Minimum Fee, Non-resident withholding, and Composite income tax is $500 or more. The required payment amount is equal to 100% of the PTEs prior year total tax liability or 90% of the current year tax (whichever is less). For calendar year taxpayers, estimated payments are generally due on April 15, June 15, September 15, and January 15 of the following taxable year.
– Electing PTEs are no longer required to withhold tax for nonresident partners or shareholders.
Pass-through entity tax credit
– Qualifying owners of electing entities may claim a refundable credit on their individual income tax return equal to the amount of the owner’s share of the pass-through tax liability.
– The PTE entity tax election satisfies the tax liability and filing requirements of nonresident owners provided that the nonresident owner does not have any Minnesota source income other than the income from the electing pass-through entity, other electing passthrough entities, or other pass-through entities electing to file a composite return.
Credit for tax paid to other states
– A Minnesota resident taxpayer who is liable for taxes based on net income to another state is entitled to a credit for the tax paid to another state. Residents that are partners in a partnership can claim a credit for income taxes paid by the partnership to another state based on the partner’s share of tax paid by the partnership.
– The legislation provides that the credit for tax paid to another state based on a partner’s share of income tax paid by the partnership is also available to members of a limited liability company.
Planning opportunities
– To lock in the benefits of the PTE election sole proprietors and single member LLC’s should consider forming entities that are either taxed as partnerships or S corporations to qualify. This can include profitable trades or businesses, rental real estate, or farms. Partnerships allow the most flexibility as asset transfers in and out of these entities are generally tax-free which would not be the case with entities taxed as S Corporations. Possible options for transferring an ownership interest includes adding a spouse, parent, or child as an owner. Do not utilize a small interest in a corporation as this would not meet the qualifying entity definition.
– Make sure that PTE’s are qualifying entities by changing ownership to remove partnerships, LLC’s other than a disregarded entity, or corporations as a partner, member, or shareholder.
– Create a partnership by contributing partnership interests of otherwise non-qualifying entities into a partnership holding company.
– If presented with the option to work as an independent contractor or employee, the contractor option would provide an opportunity to form PTEs to get the benefit of the state tax deduction.
– Review current year estimated tax payments paid by the individual owners as the new state tax deduction may reduce the federal estimated tax due and the refundable Minnesota credit will most likely reduce or eliminate the state quarterly estimated tax due to Minnesota.
– PTE tax should be paid by 12.31.21 for cash basis taxpayers if deduction is desired in year 2021. Accrual basis PTE taxpayers should be able to deduct the accrued PTE tax liability.
The IRS notice issued in November 2020 provided the golden opportunity for Minnesota to structure state tax payments at the entity level to lessen the impact of the $10,000 state and local tax limitation faced by individual taxpayers. Minnesota now joins the list of states that have changed their tax rules to allow PTE’s to pay tax at the entity level. Please contact your Boyum Barenscheer advisor if you have any questions.