Some practices can benefit from a state tax strategy
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Practices may find this short primer on state pass-through entity election and year-end tax tips helpful to determine whether they can benefit from a state tax strategy or create some tax savings before Jan. 1, 2023.
Readers of this column may be aware that the Tax Cuts and Jobs Act (TCJA) of 2017 imposed a $10,000 limitation on the state and local tax deduction for individuals who itemize their deductions on their federal income tax return.
The state and local tax (SALT) deduction cap applies under current law through December 31, 2025. This drastically limits the ability of taxpayers in states with state income taxes to take federal deductions, but also limited many individuals who pay high state and local property taxes from fully deducting these expenses. The TCJA did not impose any similar cap on state and local taxes incurred and paid by businesses.
In response, many states have added an elective pass-through entity (PTE) tax which allows partnerships and S corporations to elect to be taxed at the entity level for state income tax purposes. Partners and shareholders of entities that elect to pay this tax are then generally allowed to either claim a credit on their individual state income tax return or exclude their distributive share of pass-through income from their personal state income tax return. Since the business can deduct state income taxes from its federal tax return, the shareholder or partner’s federal pass-through income is reduced, effectively allowing the owner to receive a federal tax deduction for state income taxes on his or her business income.
While only 16 states had PTE taxes prior to 2022, another 12 states have added this option in 2022, and Missouri has added it to become effective in 2023. In addition, three more states (Iowa, Pennsylvania and Vermont) have legislation pending. When one considers that nine states have no owner level personal income tax, this leaves only nine states that have not yet proposed or enacted PTE taxes. States that have not yet proposed or enacted as of the writing of this article include Delaware, Hawaii, Indiana, Kentucky, Maine, Montana, Nebraska, North Dakota and West Virginia. Connecticut is the only state that makes the PTE tax mandatory.
Elections subject to state PTE tax
In determining whether having an election be subject to your state’s PTE tax is right for your practice, consult with your CPA. Several factors will need to be considered in making this decision. The timing of the election is important, along with the need for estimated tax payments. Some states have determined they will not impose underpayment penalties when estimated payments are not made in a timely manner on a new PTE election.
The practice must also consider whether the election impacts all owners or only a portion of owners.
For example, if some owners live in states with no state income tax and have only minimal or no tax due in the state where the election would be made, a PTE election would have a negative impact on those owners. It is also important to understand whether your state’s election is an annual election or whether it is binding for future years. These analyses can be done by your CPA who will be familiar with your state’s laws and their impact on the owners of your practice.
In some states, only entities with individual owners can make the election. Therefore, if an owner owns his or her interest through an individual entity, the election may not be available for the practice. Some states allow for an owner-by-owner election to participate, thus individual owners can determine whether the election is beneficial to them. If not all shareholders participate, there needs to be consideration for S corporation owners to determine that distributions are not disproportionate. While the IRS has not yet issued guidance on this, the American Institute of Certified Public Accountants has recommended that PTE tax payments follow composite payment deemed distribution treatment.
Perhaps the best news about the PTE tax solution is the IRS essentially blessed this workaround to the SALT cap in Notice 2020-75. In this notice, the IRS clarified that partnerships and S corporations can deduct state and local tax payments at the entity level for federal purposes in computing taxable income or loss.
Consider nuances
There are many nuances for businesses and medical practices to consider with each state’s particular PTE tax election. Practices that have tax liability in multiple states will have further items to consider. Most importantly, we encourage physicians to work with their CPAs and advisors to determine the rules in their states and how a PTE tax election would impact practice owners. In some states, the election is still available for 2022 taxes.
Since we are approaching the end of the year, here are other timely tax-savings tips:
Maximize tax benefits of your qualified retirement plan
Qualified retirement plans include 401(k)s, profit-sharing plans, money purchase plans, defined benefit plans or even simplified employee pension plans or savings incentive match plans for employee IRAs, for these purposes. Since contributions are tax deductible, maximizing them before year-end is often wise. Be sure that your plan is not “outdated” and allows the most favorable contributions for physicians compared with all employees.
Prepay 2023 expenses in 2022
As the year winds down, we typically counsel doctors with cash basis practices to prepay some of the following year’s expenses in the present year. As long as the economic benefit from the prepayment lasts 12 months or less, this can be done. Getting the deduction today, rather than next year, creates a time value of money benefit.
Implement proactive loss/gain harvesting
One advantage of holding a diversified portfolio is that, if structured properly, the securities typically will not move in tandem. This divergence of returns among asset classes not only reduces portfolio volatility, but also creates a tax planning opportunity. When some holdings within a portfolio have experienced gains, while others have declined, an astute physician can save thousands of dollars in taxes by performing strategic tax swaps prior to year-end. This may be true in 2022 for long-term investments that, despite being down significantly this year, are still up from inception.
It is important to understand the rules relating to wash sales when executing such tactics. Because the laws are confusing and a mistake can result in additional tax liability, make certain your advisor is well-versed in tax loss harvesting.
Reference:
Wealth Planning for the Modern Physician and Wealth Management Made Simple are available free in print or by ebook download by texting HEALIO to 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
For more information:
Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon practicing at Northwestern Medicine in Warrenville, Illinois. He can be reached at sanjeevbhatia1@gmail.com or @DrBhatiaOrtho. David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group www.ojmgroup.com, where Carole C. Foos, CPA, is a partner and tax consultant. They can be reached at 877-656-4362 or mandell@ojmgroup.com. You should seek professional tax and legal advice before implementing any strategy discussed herein.
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