In July, Minnesota joined at least 15 other states by enacting a new pass‐through entity tax election available to business entities taxed as S Corporations or Partnerships. The pass‐through entity tax election is effective for tax years beginning in 2021, and allows qualifying business entities to pay state income taxes on the business income to Minnesota at the entity level rather than at the individual level.
Why Would a Business Entity Make the Election?
The new law serves as a work around to the itemized deduction limitation for state and local taxes commonly referred to as the SALT Limitation. Under current law, individual taxpayers can only deduct up to a maximum $10,000 of state taxes on their federal individual income tax return. State taxes includes both state income tax and real estate taxes. Alternatively, business entities do not have a $10,000 limit on the deduction for state income taxes; therefore, the payment of the state pass-through entity tax would reduce the federal taxable income reported on Schedule K-1. The individual owners of pass‐through entities would then effectively receive the benefit of deducting the full amount of state income taxes on their K‐1 income.
How Is the Election Made?
The election must be made by owners who collectively own more than 50% of the pass‐through entity and is binding on all owners. The election also must be made by the extended due date of the tax return and is irrevocable for that year. It is only binding for that tax year and must be made again in subsequent years.
Even though the formal election is not due until after the close of the tax year, the entity would want to consider making any estimated tax payments during the course of the tax year if they do intend to make the election.
How Is the Pass-through Entity Tax Calculated?
The pass‐through entity tax is calculated by multiplying MN source taxable income at the top MN individual income tax bracket (9.85%). See the example below.
MN Taxable Income
MN Tax Rate
MN Pass-through Entity Tax
Federal K-1 Taxable Income
The benefit of making the election is the reduction in federal taxable income by the full amount of the pass-through entity tax paid to Minnesota. For purposes of calculating personal Minnesota income taxes, each individual owner would receive a credit for the Minnesota taxes paid by the entity proportional to their ownership.
Please reach out to us if you would like to discuss the potential benefits and steps to making the election for tax year 2021 in Minnesota or one of the other applicable states.