Update (3/25/22): DFA recently posted election and estimated payment forms on its website, as well as an FAQ page with guidance about the PET and making the election.
This article is authored by WLJ Tax attorneys Matthew Boch and Cal Rose.
To download a PDF version of this article, click here.
In 2022, businesses have their first opportunity to elect to pay the Arkansas passthrough entity tax rather than have the state income tax obligation pass through to a business’s owners. In many instances, particularly for businesses with in-state operations and ownership, the passthrough entity tax can shift the state and local tax (SALT) deduction to the business entity level to allow full deductibility. This can result in up to 2% tax savings (5.5% Arkansas rate multiplied by the 37% top marginal federal rate) for many taxpayers, but there are many variables and complexities to consider. With the April 15th deadline for 2022’s first quarter estimated tax payment approaching, business owners should consult their tax advisors about whether to elect into the Arkansas passthrough entity tax.
Most closely held businesses are passthrough entities, meaning that the income of the business flows or “passes” through to its owners for tax purposes. Owners of passthrough entities normally pay state income taxes at the individual level and then deduct the state income tax as an itemized SALT (state and local tax) deduction under I.R.C. § 164 on their federal return. To raise revenue and offset the effects of other tax cuts, the 2017 Tax Cuts and Jobs Act created a “SALT cap,” which generally limited an individual taxpayer’s federal deduction for state and local taxes to $10,000. I.R.C. § 164(b)(6)(B).
In response, states devised various workarounds to allow full deductibility of state and local taxes with limited success. When the dust settled, the most effective SALT-cap workaround appeared in the form of entity-level taxation: rather than passing through an entity’s income to its owners on their individual returns, the entity itself pays the tax and the owners receive an exclusion or credit to prevent double taxation. Essentially, the tax incidence shifts from the owners to the business itself. The IRS recognized the validity of this approach in Notice 2020-75 (Nov. 9, 2020).
Following the IRS’s blessing, many states rushed to enact new passthrough entity taxes in 2021 (a handful had them before), and Arkansas led the way with the passage of the Elective Pass-Through Entity Tax Act via Act 362 of 2021, which was sponsored by Representatives Joe Jett and Robin Lundstrum and Senator Jonathan Dismang.
The Passthrough Entity Tax (PET): How It Works
Under Arkansas’s law, a business that opts in to the Passthrough Entity Tax becomes subject to a flat tax at the top marginal individual income rate, which is currently 5.5% (2.75% for capital gains). Ark. Code Ann. § 26-65-103(b)(1)(A)-(B). The entity’s owners then exclude the taxed income from their Arkansas return, thereby avoiding double taxation at the state-level. Ark. Code Ann. § 26-51-404(b)(35)(A).
From a federal tax perspective, the result is that the entity will have more state tax expense and therefore will distribute less income to its owners. In other words, the reported income on the K-1 will decrease by the amount of the tax paid directly by the entity, which in turn reduces the amount of flow-through income recognized by the entity’s owners.
Elections and Estimated Payments
The Arkansas passthrough entity tax is optional and requires businesses to explicitly opt in to this regime. Owners holding more than 50% of the voting rights must elect annually before the due date—including extensions—of the entity’s income tax return. Ark. Code Ann. § 26-65-102(1). The election, if made by owners holding at least 50% of the voting rights, is effective and binding on all owners of the entity. The election is year-by-year; it does not lock in the taxpayer for later years.
The deadline for estimated payments, however, may force an earlier decision: Quarterly estimated payments are still due beginning with the fourth month of the year (April for calendar-year taxpayers). Ark. Code Ann. § 26-65-107. Failure to make estimated payments results in penalties and interest. Expect guidance and forms from DFA imminently, but DFA will likely be unable to shift estimated payments from an entity to its owners or vice versa. Ideally, businesses and their owners should make a tentative decision about whether to opt in to the PET regime and make estimated payments accordingly.
Business owners should note that paying state income taxes at the entity level will have cash flow implications. The business will have less money to distribute, but the owners will avoid estimated state taxes on the pass-through income, which could impact current-year budgets for distributions and draws.
Potential Benefits and Disadvantages from Electing the Passthrough Entity Tax
As noted above, the main goal driving the adoption of the passthrough entity tax is to minimize the effects of the federal SALT cap by creating a federal deduction for Arkansas income taxes paid. Besides the SALT cap, which is set to expire in 2026, there are other possibilities for savings when federal itemized deductions are limited. For example, a taxpayer facing federal alternative minimum tax (AMT) could realize a benefit from taking deductions at the entity level. Additionally, a business owner may be able to get the benefit of the SALT deduction at the entity level while also taking the standard deduction at the individual level.
While the federal benefits are significant, there are some potential drawbacks on the state level. The PET is a flat tax of 5.5% rather than a progressive tax through a graduated tax bracket, which will likely result in a slightly higher state-tax liability. Net operating losses or tax credits from previous years maybe stranded at the individual level if the passthrough entity tax election is taken. Taxpayers who use losses from one entity to offset income from another would be limited by separate entity-level taxation.
Given these advantages and disadvantages, careful thought and planning should be given to before opting in to the PET regime. Each taxpayer’s situation is different, and business owners ultimately must run the numbers to determine whether the passthrough entity tax is beneficial.
The passthrough entity tax is often a great option for in-state businesses with in-state ownership. The election becomes more complex when multiple states are in play.
If multiple states are involved and all of them have adopted passthrough entity taxes, the laws should work together harmoniously. Arkansas, for example, also provides income exclusion for income on which another state has imposed a “substantially similar” tax. Ark. Code Ann. § 26-51-404(b)(35)(B). Such reciprocity is generally intended for state passthrough entity taxes, but a more thorough and technical analysis may be prudent to confirm the expected result. (And DFA has not yet published a list of substantially similar taxes.)
Indeed, streamlined reporting could also be a benefit for entities doing business in multiple states and with many owners. A passthrough entity tax could be used instead of a nonresident composite return.
On the other hand, out-of-state owners of Arkansas businesses who live in states with income taxes but without passthrough entity taxes should be concerned about risks of double taxation. Ordinarily, states tax their residents on their worldwide income but with a credit for taxes paid to other states. Under a passthrough entity tax, a taxpayer may not receive this benefit. Income of out-of-state owners could be taxed at the entity level in Arkansas and then at the individual owner level in their home state.
Another potential limitation would apply to Arkansas residents who own entities that apportion income across multiple states. In those instances, the passthrough entity pays Arkansas tax only on its Arkansas-sourced income. Income sourced elsewhere is not subject to the passthrough entity tax and, unless it is subject to a substantially similar tax, the income simply flows to the individual and would be taxed normally (with a credit for taxes paid to other states).
For many taxpayers the passthrough entity tax election will bring substantial benefits, reducing the effective Arkansas income tax burden by up to 2%. But the complexities, particularly for multistate businesses, call for thorough and technical analysis. With estimated payments due in April, Arkansas passthrough business owners and their advisers should be considering whether to take the elections—as if tax season weren’t busy enough!