Update on the Alabama Electing Pass-Through Entity Tax Act Enacted During 2021

[The summary information below is not complete and is for informational purposes only. The information is not intended to be, nor should it be, construed or used as tax advice or recommendation that the election discussed here be made by any particular pass-through entity; readers should consult with their tax advisors to determine if an election is appropriate for their circumstances].

In previous Beyond the Bottom Line Newsletters, we introduced you to The Alabama Electing Pass-Through Entity Tax Act (Act 2021-1 and Act 2021-423), which allows Alabama S-Corporations and Subchapter K entities (pass-through entities or PTEs) to elect to pay Alabama income taxes at the entity level. The election may be made for tax years beginning on or after January 1, 2021. Therefore, for calendar year PTEs, 2021 is the first year for which the election is available.

Elections can be made at any time during the tax year but no later than the 15th day of the third month following the close of the tax year for which the entity wishes to be taxed as an Electing PTE. Therefore, elections for calendar year 2021 are due no later than March 15, 2022, with no extension of time. In late January 2022, the Alabama Department of Revenue released additional guidance in the form of a question and answer page on Electing PTEs.

The second Q&A in this guidance confirms that the Electing PTE must submit Form PTE-E via My Alabama Taxes (MAT) by logging into MAT then going to the Pass-Through Entity account. The taxpayer will then follow the instructions to make the election. The Q&A provides screenshots of the election process. BMSS will also be providing additional instruction as needed to its clients who have decided to make the election. The election is binding for the initial year in which the election is made and for all subsequent tax years unless the entity properly elects to no longer be taxed as an Electing PTE. If you do not have a My Alabama Taxes account, you may create one for your Pass-Through Entity at https://myalabamataxes.alabama.gov/_/#1. If an election is contemplated, creating an account now would be advisable given the March 15th due date for elections for calendar year 2021.

The trend among states to adopt electing PTE taxes emerged as a measure to decrease the impact of the SALT cap. Pass-through business owners in a growing number of states may take advantage of entity-level state tax elections as a measure of relief from the $10,000 federal deduction limit for state and local taxes—the SALT cap, which was introduced under the 2017 Tax Cuts and Jobs Act, or TCJA. In general, these electing PTE statutes allow a pass-through entity to pay state-level taxes on business income—and claim a corresponding federal deduction—which, in turn, permits individual shareholders to maximize their eligible deductions subject to the SALT cap. At least 22 states have already adopted similar statutes.

Federal lawmakers continue to vigorously debate the future of the SALT cap, which is set to expire at the end of 2025. If the SALT cap is increased significantly or repealed entirely, the motivation and benefits to be derived from an election may be diminished. If the SALT cap is extended, taxpayers operating in states with workarounds may realize significant benefits, together with a new administrative burden, from electing entity-level taxes.

Although the benefits may be substantial, PTEs with multistate operations or with members in multiple states will face more complicated compliance and should make a careful analysis when deciding whether to make entity-level elections. For a PTE with multistate operations, also consider whether an election can and should be made in all jurisdictions, or only selected jurisdictions. Paying entity-level taxes in one state may affect the individual tax returns of each partner, member, or shareholder in other states where the business is subject to a filing requirement, particularly in claiming credits for similar entity-level taxes paid to another state.

Some states will not permit credits for taxes paid to other states if paid at the entity level. For example, a taxpayer in Maine that owned and operated a Connecticut S corporation was denied a credit against his Maine income tax liability for Connecticut taxes imposed on and paid by the entity. We are still awaiting guidance from the Alabama Department of Revenue regarding its position on this issue in the case of an Alabama resident owner of an electing pass-through entity that has made the election and paid the pass-through taxes to a jurisdiction other than Alabama.

Considerable variation among different state SALT cap workarounds could spell out additional heartburn for PTEs and their tax preparers tasked with navigating a slew of emerging regulatory guidance corresponding with each new workaround statute. In addition to compliance with each state election and reporting of credits, practitioners must also plan for withholding and estimated tax payments in some states—this includes requesting refunds for overpaid estimated taxes that may have previously been paid by individual owners and how electing PTE tax credits may carry forward if unused by the individual owner in the tax year paid by the entity. Business entities making the election may also expect additional compliance considerations in preparing each state Form K-1. The higher costs of compliance, including internal opportunity costs and/or external costs if the taxpayer uses a third-party tax preparer should also be considered in any cost-benefit analysis regarding an election.

Please contact your tax professional if you have any questions regarding this summary or if you’d like to discuss options for your unique circumstances and whether the election is right for you.