Over the years, the tax code has changed many times and the most recent large piece of legislation, the ‘Tax Cuts and Jobs Act, was passed in 2018. This legislation changed many ways in which taxes are figured, including decreasing tax rates, increasing the standard deduction, eliminating the personal exemption and capping the state and local tax (SALT) deduction.
In the past, individual taxpayers (which could be small business owners) have been allowed ‘itemized deductions’ including deductions for medical expenses (subject to an income limitation), mortgage interest paid on a primary or secondary residence, charitable contributions and taxes paid to state and local taxing agencies. The deduction for taxes paid to state and local taxing agencies generally includes either income taxes or sales taxes paid, along with real estate taxes and ad valorem (vehicle) taxes. The 2018 tax law limited the deduction for these taxes, in most cases, to $10,000, which is quickly met by most small business owners. This limit can cost small business owners thousands of dollars each year in taxes.
Since 2018, states have tried several ways of recategorizing their income taxes to allow deductions for their residents. Some states put in place programs that allow taxes to be directed to charities in an effort to allow residents to deduct those payments as charitable contributions; however, the IRS quickly realized this scheme and moved to disallow any part of a charitable contribution deduction that’s reimbursed by a state tax credit. In 2021, states found a way to help small business owners secure a federal tax deduction for income taxes paid to state tax agencies: S corporations and partnerships can elect to pay taxes on income generated by the company at the entity level, which can significantly reduce their tax burden.
Georgia’s H.B. 149, which applies to tax years beginning on or after January 1, 2022, allows owners of S corporations and partnerships to pay Georgia income tax at the entity level and eliminates the need for owners of these passthrough entities to recognize their respective share of business income on individual returns. This election, which is only available to entities that file returns on a timely basis (including extensions granted by the IRS), must be made on or before the due date for filing an applicable income tax return.
Entity level option saves owners money
In Georgia, the state income tax rate for an S corporation or partnership (currently 5.75%) applies only to Georgia-sourced income and is identical to the individual tax rate (other states, such as Wisconsin, tax entity-level income at a higher rate than the individual income tax rate – consult with your RYBD advisor if you’re a resident of a state other than Georgia). Electing to pay state income taxes at the entity level eliminates the need for a shareholder or partner to pay tax on this income personally, where that shareholder and partner would ordinarily be limited to a total of $10,000 in deductible state and local taxes and secure a federal tax deduction for taxes paid by the company.
This new election is a “check the box” decision and taking advantage of it does not require any additional forms to be filed. However, business owners who want to take advantage of this new election should consider paying estimated taxes quarterly or they may be subjected to penalties.
Potential drawbacks include issues relating to multi-state entities
Entities that file in multiple states may have issues deducting taxes paid to other states, and could even find themselves paying tax on the same income to multiple state taxing agencies, due to credit disallowance. If your small business has income in multiple states and files/pays taxes in multiple states, consult with your RYBD advisor before making this decision.
Explore making an entity-level tax election during tax planning
Business owners who are considering electing this new way of paying state income taxes at the entity level should consult with their RYBD advisor to explore the ramifications of this decision before taking action. A good time to explore the potential impact of this decision would be during quarterly or annual tax planning. This discussion can prove pivotal for shareholders and partners with a tax on business income that they’re currently unable to deduct on their federal income tax returns.
Tax planning keeps business owners ahead of changes to the tax code like this one. Contact us to see how we, at RYBD, can help you and your small business in planning to take advantage of opportunities to save tax.