The AICPA Tax Executive Committee has released another letter[1] to the IRS regarding additional guidance needed for the state passthrough entity taxes beyond what was provided in Notice 2020-75.[2]

The AICPA summarizes their requests in this letter as follows:

We recommend:

1. The SITP liability is deductible in accordance with the partnership or S corporation’s method of accounting.

2. The SITP liability is a specifically identified tax and accordingly, a taxpayer should be entitled to adopt the recurring item exception method of accounting with respect to the liability.

3. An entity that is unable to make an entity level election until a year subsequent to the taxable year of imposition should be allowed to make a Federal election to deduct the tax in the taxable year of imposition or the following year (similar to the treatment of plan contributions made on account of a tax year but after the year they relate to under section 404(a)(6)).[3]

Deduction and Taxpayer’s Method of Accounting

The AICPA first deals with the issue created by the implication in Notice 2020-75 that the passthrough tax must be paid by the taxpayer’s year end to obtain a deduction.

The language in Section 3.02(3) of the Notice causes confusion amongst taxpayers and tax practitioners as the Notice indicates a SITP is deductible for the taxable year in which the payment is made. In response to a previously issued Treasury Regulation intended to address state and local government programs intended as workarounds to the Federal $10,000 state and local deduction cap, taxpayers and advisors are closely hewing to following the four corners of the Notice.

The Notice does not make mention of an entity’s method of accounting controlling the timing of the deduction and only references payment, leading many to question whether the deduction is to be taken on a cash basis method of accounting. However, to be a SITP the tax must be an income tax and must be directly imposed by the state (or other domestic jurisdiction) on the partnership or S corporation.[4]

The AICPA recommends:

The AICPA recommends that Treasury and the IRS issue guidance that the deduction for a SITP is deductible in accordance with the passthrough entity’s established method of accounting.[5]

After discussing the overall rules for accrual methods, the AICPA concludes:

All told, the basis for the deduction to be claimed in accordance with the taxpayer’s method of accounting and that the PTET liability is an eligible recurring item exception item is sound. Taxpayers though, in an abundance of caution, would appreciate guidance from the IRS affirmatively stating so.[6]

Recurring Item Exception

The AICPA also makes a case that taxpayers should be allowed to use the recurring item exception for state passthrough entity taxes:

The recurring item exception must be consistently applied to a type of item, or for all items, from one taxable year to the next to clearly reflect income. In other words, the recurring item exception is a method of accounting and as such, if a taxpayer is not on a recurring item exception method for a type of item, it must request consent of the IRS to change its method of accounting.

A passthrough entity may have an established method of accounting for other taxes, such as state income, franchise, or real property taxes. However, as 29 states now have entity level tax regimes, the state income tax liability may take on more significance. In the interest of administrative benefit for both taxpayers and the IRS, the IRS should state that a SITP liability is a separate item for purposes of the ability to adopt the recurring item exception method of accounting.[7]

The AICPA recommends:

The SITP liability is a specifically identified separate tax and, accordingly, a taxpayer should be entitled to adopt the recurring item exception method of accounting with respect to the liability.

Alternatively, if the IRS disagrees that the SITP is a separate item from state income taxes, the IRS should plainly state this determination and provide an eligibility restriction waiver for a prior five-year change for the timing of incurring liabilities for state income taxes to allow taxpayers to adjust any methods of accounting for these liabilities.[8]

The AICPA provides the following analysis in support of this recommendation:

Treasury Reg. § 1.461-5(d)(1) provides that a taxpayer is permitted to adopt the recurring item exception as part of its method of accounting for any type of item for the first taxable year in which that type of item is incurred. In addition, the recurring item exception must be consistently applied with respect to a type of item, or for all items, from one taxable year to the next in order to clearly reflect income.

As the Treasury and IRS are aware, the SITP is for a tax directly imposed upon an entity without regard to whether the imposition of and liability for the income tax is the result of an election by the entity. While the item is a state income tax, the separate definition of a SITP by the IRS recognizes this tax as a separate item from a general state income tax.[9]

Ability to Choose Year When Election Made After Year End

The AICPA notes that the fact that many states don’t allow an election to be made until after year end creates concerns about the year of deduction:

As noted, section 3.02(2) of the Notice states SITPs are deductible when paid. However, section 3.02(1) of the Notice defines SITPs as amounts paid to satisfy a liability for income taxes. There is confusion among practitioners about whether a taxpayer would have a liability for income taxes in the current taxable year for an elective PTE tax where the election is made after the end of the current taxable year, especially in states where the statute does not permit an election to be made any earlier than the following taxable year. Some practitioners have been advising taxpayers to enter into a binding agreement directing the passthrough entity to make an election to pay PTE tax in order to claim a deduction in the current taxable year. In the interest of administrative benefit, the IRS should allow taxpayers to make a binding election on its timely filed tax return to claim a current year deduction for SITP arising from any PTE tax imposed on current year taxable income.[10]

The AICPA recommendation is:

The AICPA recommends that with respect to elective SITP regimes, the IRS allow taxpayers to treat the SITP as a liability for the year in which the tax is imposed (meaning a fixed liability in the case of an accrual method taxpayer and an otherwise deductible liability in the case of a cash basis taxpayer) in situations where the state does not provide a mechanism or procedure for taxpayers to elect into the PTET prior to the end of the tax year for which the tax is imposed.[11]

The AICPA describes the problem as follows:

In situations where a state revenue authority lacks a formal procedure for a taxpayer to make an election to pay PTE tax on current year taxable income until the following year, there is uncertainty whether the all events test is met during the current taxable year. Generally, practitioners have interpreted the all events tests as denying a SITP deduction of an elective PTE tax where an affirmative election to pay PTE tax is not made on or before the end of the taxable year. However, other practitioners have suggested the fact of the liability is fixed as of the end of the year since by statute income tax is assessed on any taxable income earned by a passthrough entity as of the end of the taxable year. A PTE tax election only acts to shift the liability from the individual owners or partners to the entity itself rather than establish that a liability exists.

As a work around when an election to pay PTE tax is unavailable on or before the end of the taxable year, some practitioners have been advising taxpayers to put in place binding agreements before the end of the taxable year mandating the passthrough entity make the election in the following taxable year. However, even with such an agreement in place, there is still uncertainty for taxpayers whether the IRS will respect the substance of such an agreement or what specific information would have to be included in such an agreement to avoid a challenge by the IRS. This process also places an administrative burden on taxpayers to draft such agreements, especially for smaller taxpayers who may be lacking counsel, and on the IRS to review such agreements upon examination for completeness.[12]

The letter goes on to justify the recommendation:

PTE taxes are put in place by states to change the state tax treatment of individual owners and partners in certain passthrough entities. By issuing the Notice and treating PTE taxes as a deductible expense for Federal income tax purposes, Treasury has signaled its apparent agreement that changes to state tax laws that shift the state tax liability from the individual to the passthrough entity removes such tax from the limitation on individual SALT deductions. From a policy perspective, there seems little reason to deny similar treatment to individuals who are owners or partners in passthrough entities which conduct business in states where the taxpayer is certain of paying PTET but is only prevented from making an affirmative election to pay PTE tax during the taxable year by state statute.

Therefore, for the sake of eliminating uncertainty and reducing administrative burden on both taxpayers and the IRS, the IRS should allow a passthrough entity to make a binding election on its timely filed tax return to treat any PTE tax imposed on current year taxable income as fixing a liability to pay PTE tax as of the end of the that taxable year regardless of when an actual election is allowed by the state revenue authority, and any payment of such PTE tax to be treated as a deductible SITP in the year paid.[13]

[1] AICPA Tax Executive Committee Letter, “RE: Additional Guidance Needed on Section 461 Accrual Basis Taxpayers and Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes,” October 4, 2022

[2] Notice 2020-75, November 9, 2020, https://www.irs.gov/pub/irs-drop/n-20-75.pdf (retrieved October 7, 2022)

[3] AICPA Tax Executive Committee Letter, “RE: Additional Guidance Needed on Section 461 Accrual Basis Taxpayers and Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes,” October 4, 2022

[4] AICPA Tax Executive Committee Letter, “RE: Additional Guidance Needed on Section 461 Accrual Basis Taxpayers and Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes,” October 4, 2022

[5] AICPA Tax Executive Committee Letter, “RE: Additional Guidance Needed on Section 461 Accrual Basis Taxpayers and Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes,” October 4, 2022

[6] AICPA Tax Executive Committee Letter, “RE: Additional Guidance Needed on Section 461 Accrual Basis Taxpayers and Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes,” October 4, 2022

[7] AICPA Tax Executive Committee Letter, “RE: Additional Guidance Needed on Section 461 Accrual Basis Taxpayers and Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes,” October 4, 2022

[8] AICPA Tax Executive Committee Letter, “RE: Additional Guidance Needed on Section 461 Accrual Basis Taxpayers and Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes,” October 4, 2022

[9] AICPA Tax Executive Committee Letter, “RE: Additional Guidance Needed on Section 461 Accrual Basis Taxpayers and Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes,” October 4, 2022

[10] AICPA Tax Executive Committee Letter, “RE: Additional Guidance Needed on Section 461 Accrual Basis Taxpayers and Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes,” October 4, 2022

[11] AICPA Tax Executive Committee Letter, “RE: Additional Guidance Needed on Section 461 Accrual Basis Taxpayers and Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes,” October 4, 2022

[12] AICPA Tax Executive Committee Letter, “RE: Additional Guidance Needed on Section 461 Accrual Basis Taxpayers and Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes,” October 4, 2022

[13] AICPA Tax Executive Committee Letter, “RE: Additional Guidance Needed on Section 461 Accrual Basis Taxpayers and Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes,” October 4, 2022