Entity Types Affecting Income Tax Collection Requirements

State and Local Tax includes many factors that play a major role in the determination of tax collection requirements.  This article will examine how entity type impacts the requirements for the collection of income tax. 

How does entity type impact income tax collection requirements? 

Most state requirements for income tax lean towards a physical presence or economic nexus threshold. While for some states, it is simply doing business within their state or electronically communicating with the residents thereof.  Although these requirements are equally applicable across the spectrum of entity types, pass-through entities can create an interesting dynamic.  A pass-through entity (sometimes referred to as a flow-through entity) is defined as “a business entity (such as a sole proprietorship, partnership, or S corporation) whose income is taxed as the owner’s personal income at the individual rate rather than as business income for federal income taxes” (Merriam-Webster).  

Why would a company being a pass-through entity be advantageous you might ask?  The answer is because of the SALT cap workaround.  The SALT cap workaround has become a necessary evil for many companies and individuals to avoid the $10,000 federal cap on state and local tax deductions.  The SALT cap workaround statutes vary from state to state, but the objective achieves the same goal. Typically, the workaround imposes a state tax at the pass-through entity level, and then the owners either receive a state tax credit, or deduction, on their personal income returns. Those state taxes reduce the owner’s share of federal taxable income, and the owner’s state tax obligation is reduced by the credit or deduction. 

Pass-through entity tax regulations 

A few examples of pass-through entity tax regulations include California’s, which (for tax years 2021 and later) allow qualified taxpayers to elect to pay a tax of 9.3% on each consenting shareholder’s pro-rata share of the PTE’s income that is subject to California’s laws.  Another example is New York’s statute, which allows for a pass-through entity to elect to pay tax ranges from 6.85% to 10.9%. This depends on the entity’s state taxable income, and the shareholder is allowed a credit for their distributive share of the entity’s tax.  Another example is Illinois which allows for a pass-through entity to elect to pay a 4.95% tax on their Illinois income and allow each resident shareholder a credit of their distributive share of the entity’s tax. 

While it is important to note a company’s tax status as a pass-through entity doesn’t necessarily factor into nexus criteria. Its status plays an important role in determining the tax rates assessed and credit amounts available.  Therefore, it is important that companies evaluate the pros and cons of their entity status. As that determination impacts their available state taxes, credits and deductions. 

References 

Merriam-Webster. (n.d.). Pass-through entity. In Merriam-Webster.com dictionary. Retrieved March 7, 2023, from https://www.merriam-webster.com/dictionary/pass-through%20entity