The PTE (Passthrough Entity) Problem

by Tom Yamachika, President, Tax Foundation Hawaii

There are a couple of measures moving in this year’s Legislature that are important for the many small businesses here that do business in passthrough entities (partnerships or S Corporations, mostly). 

So, here’s the problem.  The Tax Cuts and Jobs Act of 2016 put a $10,000 hard cap on individual taxpayer deductions for state and local taxes.  No limit is placed on other entities like corporations.

If an individual conducts business as an S corporation or a partnership (most small businesses are in that form), the state income taxes of the business aren’t paid by the business itself, but are instead paid by its owners according to their respective shares in the business; a 30% owner, for example, would include 30% of the business’s net income on the owner’s individual tax return.  But if state tax on that amount goes over $10,000, then the owner involved winds up with a non-deductible expense. This is an issue here in Hawaii because our individual income tax rates can go up to 11%, second highest in the nation.

Last year, lawmakers enacted a workaround.  They passed a bill providing a “passthrough entity election” (PTE election).  An electing company would pay 11% (because 11% is the highest individual tax rate) on its net income. The company, not the owners, would be able to deduct the 11% without limit, and the owners would get credited with their proportionate shares of the tax payment.  The Internal Revenue Service came out with some guidance, Notice 2020-75, that says this works.  So far, so good.

Hawaii’s bill, however, also had a feature that wasn’t so great. The credit was provided on a “use it now or lose it” basis; it couldn’t be refunded or carried to any other year. If it wasn’t used in the current year, any excess was lost.  This was harsh because the credit wasn’t for magic money that the State gives people for doing certain things that it considers socially desirable; it was for real money that the business paid to the State on behalf of its owners.

Most normal business owners don’t make nearly enough to drop into the 11% tax bracket.  For those people, the benefit from the federal deduction was often outweighed by the state tax forfeiture that would result from the “lose it” portion of the credit.

Put another way, the benefit from the PTE election was greatest when the taxpayer was wealthy enough to have income from sources other than the passthrough.  The excess credits would offset the tax from those other income sources and wouldn’t be lost.

Well, that is a screwed-up situation, probably not at all what our lawmakers intended.

The bills moving through the Legislature, HB 1803 and SB 2725, would help to solve the problem by allowing the excess credit to be carried forward to future years (both bills), or reducing the rate from 11% to 9% (House bill only).  Both changes appear to help with the problem presented.  Hopefully, lawmakers will consider these bills seriously as the legislative session advances.