What is the "NC pass-through entity tax"?
Hi everyone, hope you had/are having a nice summer !
I haven't done an info. post in a while, and something I wanted to bring up and explain a bit is North Carolina's new "pass-through entity tax election". I also wanted to explain that I looked at this election for my clients and decided that overall it generally isn't something that should be done for "small businesses".
What is it and why was it created ?
One of the changes made starting 2018 was to cap the Schedule A (federal itemized deductions) state tax deduction at $10,000. One of the state taxes that could be deducted here was the NC personal income tax. Many states (including NC) found a "work around" that enabled NC personal income taxes to be deducted another way, so it didn't have to count as part of the $10,000. Briefly, an S-corp or partnership can elect to pay the NC income tax on the income that would instead otherwise flow through to the shareholders or partners, for them to pay the tax on. The overall NC personal income tax would be the same, it is just the geography of the deduction that would change.
Note that this election could also benefit any taxpayer that is not itemizing deductions at all. When the pass-through entity pays the tax, its federal income is reduced and that reduced income flows through to the partners/shareholders. Essentially, this is a tax deduction for personal state income tax that otherwise isn't available to them on their federal 1040s.
Why NOT elect this if it can save some tax?
Saving some tax often comes at a price that isn't worth it, and in this case, the savings needs to be enough to outweigh the costs and risks. What are the costs and risks?
Complex compliance that is still being worked out by NC - the entity needs to make quarterly estimated taxes, and unless you'll be figuring this out yourself, you'll have to pay some one to figure it out for you. Also, certain deductions may not be allowed under the election. Finally, the election is particularly complex if doing business in more than one state (due the credit for taxes paid in other jurisdictions)
The $10,000 cap is set to end in a few years - is it worth doing when the issue is likely going away in 2025?
S-corporations - reasonable compensation for shareholder/employees has always been a high risk issue, but with the recent announcement that the IRS plans to hire and conduct more audits, I don't believe this is a good time to make an S-corp a tax-paying entity.
Overall, I am of the opinion that unless the partnership or S-corp is particularly large, it is not worth doing this election. For any clients that want more info, please let me know.