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Pass-through Entities Can Now Elect to Pay Alabama Income Tax at the Entity Level

On May 4th, Governor Kay Ivey signed into law HB 588 which, beginning with the 2021 tax year, allows Alabama S-Corporations and Subchapter K entities (pass-through entities or PTEs) to elect to pay Alabama income tax at the entity level. This law has Alabama joining a growing number of states attempting to circumvent some of the punitive effects of the Tax Cuts and Jobs Act (TCJA) of 2017.
Alabama’s HB 588 seeks to minimize the consequences of the $10,000 SALT limitation on the Federal Schedule A of Individual Taxpayers. Taxpayers opting in on the new election would receive the tax benefits as though the SALT limitation weren’t in place. Individual PTE owners who take the standard deduction could also benefit from the election.
As designed, the state taxes paid by the entity will be deductible on the PTEs Federal tax return and will flow through as a reduction of K-1 income reported to the owners, which results in a reduction of Federal taxes paid by the owners.
Because the election has been created solely for the purpose of circumventing the Federal limitation, it may stand on shaky ground. This law joins others in a recent trend of tax laws aimed squarely at reducing Federal taxes for the benefit of the state’s residents. However, Congress and the IRS aren’t unaware of this attack on their budget and similar laws over the past few years have been thwarted by disallowing the deduction. Just a few years ago, Alabama residents were faced with the IRS disallowing the Federal charitable contribution deductions for payments made to Scholarship Granting Organizations that were paid in lieu of Alabama tax payments.
Here are some additional notes about the PTE Election under HB 588:
  • The election can be made at any time between January 1st of the tax year and the return filing date without extension (March 15th for calendar year PTEs)
  • Once made, the election is in effect perpetually, but can be revoked. Tax law does not contain a limit on revocation and election. With care, we believe it could be chosen annually.
  • The election can be made on an entity-by-entity basis. This allows taxpayers to make the election on a profitable entity, and not on a loss entity that wouldn’t receive a benefit under the election.
  • The entity level tax is 5% of Alabama apportioned taxable income, not Federal income. Multi-state businesses should consider state apportionment when considering the effect of the election.
  • Tax savings for business owners from the election can be estimated at 1%-2% of their Pass-Through Entity’s Net Income. A variety of factors impact the net savings, including the marginal Federal tax rate of the PTE owners. A Taxpayer who normally receives a Schedule K-1 reporting $500,000 in income could save between $5,000 and $10,000 in Federal taxes.
  • Because the PTE tax is paid by the entity, not individuals, the entity making the election is required to make quarterly estimated tax payments. PTE owners should adjust (reduce) their individual quarterly estimates accordingly.
  • If the election is made mid-year, an underpayment of estimated tax penalty should be expected for the missed quarters. With the original enactment of the election, Alabama forgave penalties incurred due to missing the 1st quarter, but no such exemption applies going forward.
  • If the election is made, the PTE owners will still report their Alabama K-1 as income on their individual Alabama return and will report a credit for their share of entity level taxes paid by the PTE. If the PTE pays an entity level tax of 5%, and the PTE owner’s net tax rate to Alabama is 3.5%, the PTE owner may end up with an overpayment on their Alabama individual tax return. The overpayment can be refunded or applied to a future year.
  • Composite taxes for nonresident PTE owners are currently treated as distributions to the owner receiving benefit from the tax payment. The taxes paid under the new PTE election will benefit all PTE owners (resident and nonresident) and would be tax deductible for Federal purposes at the PTE level.
  • The election is based on taxable income of the PTE. Any overpayment of estimated taxes paid by the PTE is currently expected to be refunded or applied to a subsequent year at the PTE level. At this time, there is no guidance from the Alabama Department of Revenue about the treatment of overpayments.
The law was passed in May, and the only guidance released so far is related to the calculation and submission of quarterly estimated taxes. A lot of questions remain unanswered, to date. We will continue to monitor the situation and provide updates once additional guidance is released.
As always, if you have any questions please contact your Dent Moses advisor.