Minnesota’s pass-through entity tax credit
What has, hasn’t changed
Ed Zollars, CPA, Kaplan Financial Education | November 2021 Footnote
Editor's note: Updated October 29, 2021
When the IRS issued Notice 2020-75 in November 2020, it represented a vindication of the approach first taken by Connecticut to work around the limitation on the deduction of state and local taxes on Schedule A of Form 1040. The IRS endorsement of this approach — which had been adopted in modified forms by several other states by that time — pushed many states that had not adopted an entity level tax mechanism like Connecticut’s to enact one in 2021.
Minnesota was one of those states that adopted such a tax in 2021, found at Minnesota Statutes 2020, Section 289A.08, subdivision 7a. The effective date of this provision is for taxable years beginning after Dec. 31, 2020. Thus, calendar year partnerships and S Corporations are eligible to elect to have this tax apply for 2021.
Basic structure of the tax
A Minnesota partnership, limited liability company or S Corporation (other than those that have a partnership, limited liability company or corporation as a member)
1 may elect
2 to pay a tax at the highest state tax rate, 9.85% for 2021.
3 The tax is imposed on the income of
qualifying owners from the entity.
4
Qualifying owners are defined as:
- A partner, member or shareholder of a qualifying entity (resident or nonresident individual or estate).
- A trust that is a shareholder of a qualifying S Corporation. Note that this excludes trusts that are partners in a partnership.5
Income is generally defined as items of federal adjusted gross income for the qualifying member subject to certain Minnesota modifications.
6 The Minnesota Department of Revenue posted a near final draft version Schedule PTE dated Aug. 25, 2021, to be filed with Form M3 or M8 that will be used to elect and compute the 2021 pass-through entity tax.
7
The election may be made by a qualifying entity in which the taxes of a qualifying owner are limited by the $10,000 limit on deducting state and local income taxes for federal tax purposes.
The election:
- Must be made on or before the due date, including extensions, of the entity’s pass-through entity income tax return.
- Can only be made by qualifying owners who hold more than a 50% interest in the entity.
- Is binding on all qualifying owners, not just those that elected.
- Is irrevocable once the election is made for a year.8
If you are mystified about why an entity would
elect to pay a tax that is not required to be paid, it is because the qualifying owners are going to receive a state income tax credit for the PTE tax liability paid by the entity for that owner.
9 If that tax is in excess of the tax the qualifying owner owes for the year to Minnesota, the excess is refunded.
10
Federal tax treatment
It still may not immediately make sense why entities and owners would want to go through a process that doesn’t really change the overall taxes ultimately paid but requires preparing additional forms and the costs to create them. But the federal tax treatment outlined in Notice 2020-75 of such taxes provides the reason. Put simply, the PTE tax allows individual owners to deduct state and local taxes in excess of the $10,000 limit on such taxes claimed on Schedule A.
The IRS ultimately decided that it would be difficult or impossible to issue guidance to eliminate the benefit. Notice 2020-75 points out that Revenue Ruling 58-25
11 provided that a tax Cincinnati, Ohio imposed on the profits of a partnership was treated as deductible in computing the profit or loss of a partnership, and the tax was not separately stated but rather was treated as a non-separately stated deduction in computing the partnership’s business income or loss reported on Schedule E of the individual tax returns of the partners.
12
In Notice 2020-75, the IRS announced its intention to issue proposed regulations that would follow the treatment given in Revenue Ruling 58-25. Specifically, the Notice indicates that these taxes “are deductible by partnerships and S Corporations in computing their non-separately stated income or loss.”
13 The rules will be consistent with those outlined in Section 3.02 of the Notice.
The deductible payments covered by these rules will include “any amount paid by a partnership or an S Corporation” to a state for an income tax “on the partnership or the S Corporation.”
14
But what about the fact that the owners are getting a tax credit for the amount paid and the entity is volunteering to pay this tax? It turns out that none of that matters, nor would it matter if the entity’s income was excluded from the income taxed at the individual level (as Wisconsin’s statute handles this issue). The deduction is allowed even if the entity must elect to pay it, and even if owners get tax benefits — credit or a deduction — in such a case.
15
The partnership or S Corporation is allowed a deduction for such a payment made during the tax year,
16 and the amount will be reflected in a partner’s or S Corporation shareholder’s share of non-separately stated income reported on the respective K-1.
17 The tax imposed at the partnership or S Corporation will not be taken into consideration in determining the owner’s state and local tax deduction limitation on Schedule A.
18
Issues to consider
While the rules are overall a good result for taxpayers, there are some issues.
There is some concern about how these rules would apply to a partnership or S Corporation that did not have a trade or business, but rather had only investment income. Nothing in Section 3 of the Notice seems to bar the use of these rules to apply the workaround to such investment income. Though, it is concerning that Revenue Ruling 58-25 cited to justify this Notice involved a tax solely on business profits. While most state rules — including Minnesota’s it would appear — allow a qualifying entity to elect to pay tax in such situations, clients should be advised that it is possible the IRS’s regulations may limit the application only to income of a type like that in Revenue Ruling 58-25.
The Notice only talks about allowing a deduction for payments made during the tax year on a PTE tax. While it’s difficult to fathom the justification for not allowing PTE payments accrued for an accrual basis partnership or S Corporation as a current deduction, until this issue is clarified it seems prudent to attempt to get the proper amount of any PTE tax paid by the year-end of the eligible entity. But this will also mean, from a practical perspective, that the decision to elect this treatment will need to be decided upon before year-end.
Also, the Notice specifically limits the benefit to partnerships and S Corporations. So, single-member LLCs treated as disregarded entities held by an individual, even if found eligible to make this election by the DOR, will likely only be eligible for a benefit if the LLC makes an S Corporation election. This result is consistent with the position outlined in Revenue Ruling 58-25, which only allowed the Cincinnati tax as an itemized deduction for sole proprietors.
Finally, an election may create issues for nonresident partners or S Corporation shareholders who may find that their state law will not grant them a credit for taxes paid to Minnesota if the tax is paid under a PTE election. The problem is that the individual’s Minnesota income taxes reported on the nonresident return are reduced by this tax credit. In some cases, the resident state may only allow a credit for the net Minnesota tax imposed, especially if the state law has not been updated to include such a pass-through tax option for entities in that state.
Minnesota’s law may provide some relief in this area because a nonresident with no other income from Minnesota can opt to not file a return and rather have the PTE return satisfy their filing responsibilities, much like a composite return.
19 At least other states have dealt with composite returns for years — but PTE taxes are new and not likely covered in statutes.
For this reason, any partnership or S Corporation with owners who are not Minnesota state residents will have to consider the impact of such an election on the overall liability for all state taxes for the nonresident members, not just the Minnesota tax impact.
Looking ahead
Now is the time to start addressing the issue of whether eligible partnerships and S Corporations will or will not elect to pay the Minnesota pass-through entity tax for 2021. For partnerships with only Minnesota resident individual members, it will make sense normally to make this election as long as a benefit is expected in excess of the cost of preparing the necessary forms. For partnerships and S Corporations with nonresident owners, the analysis gets more complicated.
Edward K. Zollars, CPA is an author, CPE instructor with Kaplan Financial Education and a partner in the CPA firm of Thomas, Zollars & Lynch, Ltd. He has more than 25 years of public practice experience, specializing in closely held business and individual tax issues.
1 Minnesota Statutes 2020, Section 289A.08, subdivision 7a(a)(2)
2 Minnesota Statutes 2020, Section 289A.08, subdivision 7a(b)
3 Minnesota Statutes 2020, Section 289A.08, subdivision 7a(d)
4 Minnesota Statutes 2020, Section 289A.08, subdivision 7a(b)
5 Minnesota Statutes 2020, Section 289A.08, subdivision 7a(a)(3)
6 Minnesota Statutes 2020, Section 289A.08, subdivision 7a(a)(1), Minnesota Statutes 2020, Section 290.0131, subdivision 5
7 https://www.revenue.state.mn.us/sites/default/files/2021-08/pte_21_0.pdf (retrieved Sept. 27, 2021)
8 Minnesota Statutes 2020, Section 289A.08, subdivision 7a(b)
9 Minnesota Statutes 2020, Section 290.06, subdivision 40(a)
10 Minnesota Statutes 2020, Section 290.06, subdivision 40
11 Revenue Ruling 58-25, https://www.taxnotes.com/research/federal/irs-guidance/revenue-rulings/rev.-rul.-58-25/dj0d?h=58-25 (retrieved Sept. 27, 2021)
12 Notice 2021-75, Section 2.01(5), https://www.irs.gov/pub/irs-drop/n-20-75.pdf (retrieved Sept. 27, 2021)
13 Notice 2021-75, Section 3.01
14 Notice 2021-75, Section 3.02(1)
15 Notice 2021-75, Section 3.02(1)
16 Notice 2021-75, Section 3.02(2)
17 Notice 2021-75, Section 3.02(3)
18 Notice 2021-75, Section 3.02(3)
19 Minnesota Statutes 2020, Section 289A.08, subdivision 7a(j)
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