Michigan Pass Through Entity Tax
Business taxation is often a complex matter, involving a spider web of local, state and federal tax laws, regulations and tax code. For business owners, they face the unique challenge of being taxed once at the corporate level via corporate taxes, and once at the personal level on income taxes when they pay themselves through the corporation.
As a result of the Tax Cuts and Jobs Act signed into law by then President Donald J. Trump in 2017, the corporate tax rate has been lowered considerably from the previous 35% standard to the current rate of 21%. However, paying this amount in addition to an income tax still means that business owners are left with a hefty overall tax burden. Also, as part of this act there is a $10,000 cap on state and local tax (SALT) deductions that can be made on personal Federal income tax filings.
This places a significant burden on business owners and those who have interests in partnerships or S corporations from which they receive income, as they no longer have the ability to deduct their considerable state level corporate taxes from their federal income tax filings. This means that although their federal corporate and income tax burden is lowered, their state level burden is now higher, which in most cases will result in a higher overall annual tax burden.
Changes for 2021
In response to this change under the Tax Cuts and Jobs Act (TCJA), the State of Michigan has enacted an Elective Pass Through Entity Tax, which is intended as a work around for the SALT Caps. Essentially what this does is offer individuals the choice to opt into having the state impose income taxes on their existing pass through entities (PTE) instead of the individual income taxes of the entity owners themselves. Under this change, the PTE will be subject to the same income tax rate as individual payers, which currently sits at 4.25%. Under this change however, individuals are required to stay opted in for a minimum of two years.
For those who are looking to take advantage of this change, there are certain timing considerations to keep in mind. These timing changes are dependent on whether the business is utilizing cash or accrual method of tax accounting. For taxpayers who are utilizing the cash method and seeking to take advantage of this new change in Michigan’s Pass Through Entity Tax, they should make sure the PTE taxes are paid on or before December 31st of 2021.
Those who are utilizing the accrual method of tax accounting are strongly advised to take a conservative approach and also pay their PTE taxes on or before the 31st of December 2021. This is important to ensure eligibility, as the determination of whether a taxpayer utilizing an accrual method is eligible is dependent on the application of accrual method tax accounting accrual method tax accounting rules as they are applied to each individual pass through entity. While there is a possibility that an accrual method taxpayer’s PTE would be eligible for this regardless of when taxes are paid, paying on or before the end of the year will effectively guarantee their eligibility to take advantage of the PTE tax option.
Pass Through Entities in Other States
Michigan is one of several states who have initiated special pass through entity taxes to help ease the overall tax burden of businesses and business owners. For other states, such as those without an individual income tax, this measure has yet to be implemented. Florida is the most notable of these states, with no PTE tax in place to handle the increased tax burden for businesses. This is partially due to the fact that they do not collect income taxes on individuals, LLCs, sole proprietorships and S Corps, which alleviates a large portion of the income tax burden.
While the TCJA ultimately doesn’t impact individual taxpayers, it does raise the overall tax burden for regular corporations since under Florida business tax law there is a corporate income tax, which is 5.5%. In the case of Florida, when this is combined with the $10,000 cap on Federal deductions, the overall tax burden on average will go up approximately 13% across the state. Other states with similar tax structures are likely to see the same or similar overall tax increases unless they were to come up with workarounds to allow for alternative deductions.