Pass Through Entity Tax Credit Continued

On August 27, 2021, Illinois Governor Pritzker signed into law Senate Bill 2531, which allows for a credit at the entity level for the 4.95% income tax which is normally levied at the personal level. It allows you to pay and deduct the tax at the entity level rather than on your 1040.

I will repeat that to make sure it sinks in. We get to pay and DEDUCT the additional tax at the entity level. This saves both Federal and State income taxes. Let’s use an example to explain.

Joann B. Owner has a $500,000 K-1 from an S Corp or a Partnership, and pays a 4.95% tax on $500,000 or $24,750. If we pay and deduct that tax at the entity level, then she would only pay federal and state income taxes on $475.250.

She would normally lose this deduction because of the $10,000 deduction limitation on Schedule A. But if we use the Pass Through Entity Tax Credit (PTETC) and she pays a combined income tax rate of 43%, this will save her $10.642.50 in taxes. That’s it. That’s the concept, but let’s not act like any of this is easy.

This is a brand-new tax law. So far, over 30 states have passed laws promoting PTETC’s. Why? Because it’s in the state’s best interest, it doesn’t hurt them financially, and they get their tax payments early.

Our friends at The Internal Revenue Service (IRS) issued a notice in November of 2020 regarding PTE payments. We’re yet to receive final regulations, but the notice we did receive provided some guidance.

The main issue is that these payments must be handled on a cash basis. Whether your entity files its taxes on a cash or an accrual basis, this part of your return must be done on a cash basis.

This means that all of your payments for the year in question must be paid inside that year. Any payments outside of the year cannot be applied to the year in question.

Also, the state wants these payments made in quarterly installments. Without the quarterly installments, the state will impose a small quarterly estimated tax payment penalty. These estimated tax penalties are the smallest penalties we deal with in taxation. If we began now in 2023, your tax savings would far outweigh any pitance the state would levy in estimated tax penalties.

These rules are by definition problematic, so please allow me to explain using our prior example.

Joann B. Owner had a solid year in 2022, but this year isn’t going well. Her sales and profits through June of 2023 are down 30%.

As such her quarterly estimates for the first and second quarter should be adjusted down by 30%.

Through enhanced marketing efforts and her largest competitor’s retirement, her third quarter sales jumped. She was then on her way to having a taxable profit for the year of $600,000 which is $100K higher than the prior year.

Her quarterly estimate for the third quarter would need to be adjusted so that she could catch up the smaller deposits from the first two quarters and the increased sales from the third quarter.

Then comes the fourth quarter. Since this must be handled on a cash basis, her fourth quarter payment must be paid before December 31st so that it can be counted towards 2023.

How does anyone get their numbers done by New Year’s Eve? Joann is an accrual basis taxpayer who has no idea where her Accounts Receivable, Accounts Payable, or Inventory will actually fall given the year end adjustments that must be made in her situation.

So the fourth quarter will come down to SWAG or a Simple Wild A**ed Guess. That’s something no accountant ever wants to say to any client, but that’s the reality of the situation.

The process is difficult given the rules.

Let me leave you with this.

By definition, all of the estimates we provide are based on interim financial statements that are by no means final. Variances will occur.

In order to account for some of those variances, we inflate all of our quarterly deposits by 10%. It’s always better to be over deposited than under.

If you deposit more than you should, the excess will be refunded when the returns are completed. But if you under deposit, you won’t be able to take the full credit. You can only take the credit based on taxes that are deposited inside the year.

The last part that’s difficult is the preparation of the income tax returns. If we do both your business and personal returns, then you have nothing to worry about. If you use another firm, then I would be concerned.

So far, I’ve had three returns prepared by others that came into the office to be checked. All were completed improperly. One took the credit based on payments that weren’t even made during or after the year in question.

This was nothing short of income tax evasion and we amended the returns immediately so that the entrepreneur didn’t face jail time. The owner had no idea what was happening on the return. He signed and sent it in as usual. His CPA wasn’t going to tell him that he didn’t know what he was doing and had inadvertently exposed him to a misdemeanor.

Be careful. If you’d like to talk to us about handling your returns, there’s no time like the present.

I’m not trying to scare you. This isn’t a dangerous tax position if handled correctly. We’ve gone through two taxation cycles with these tax laws in place, and the Service is yet to challenge any of them.

This is perfectly safe if done correctly. But this is also new, and most practitioners haven’t studied the process. As such, you need to be extremely careful.

I realize how complicated this is. As always, when you have questions, please don’t hesitate to contact us. We look forward to helping you save money on your taxes, and remain,

Sincerely yours,

Chris Amundson
President
Accounting Solutions Ltd.
773-267-7500
888-310-0300

www.SalarySolutions.net

www.AccountingSolutionsLtd.com

Note that the only professional services provided by Accounting Solutions Ltd. are those specified in a written communication from our office detailing the scope of services to be rendered and the terms and conditions applicable to the engagement.