Pass-Through Entity Taxes & Reporting Under GAAP
5/21/24
Introduction
In connection with changes to the Internal Revenue Code as a result of the Tax Cuts and Jobs Act of 2017, limitations were placed upon the amount of state and local taxes (SALT) deductible by individuals for personal income tax purposes. This had a significant impact on the deductible expenses for individuals who invest in pass-through entities (PTEs) such as partnerships or S-corporations.
To address this issue, the IRS issued a clarifying notice (2020-75), which permitted pass-through entities to deduct all of the pass through entity taxes (PTET) paid at the reporting level. In response to this, states created a wide variety of pass-through entity taxes to permit owners in their states to take advantage of this clarification. PTE tax election preserves the full deductibility of SALT for the investors in these PTEs leading to greater tax savings at the individual level.
The specific laws vary by state but typically offer the options to elect to file as: (1) a pass-through entity, (2) a composite return (which pays tax at the entity level but allows the entity to claim certain credits from other PTEs), or (3) a PTE return. Composite returns and PTE returns have many similarities for GAAP purposes and are collectively referred to in this article as "PTE tax".
As a result, it provides significant opportunities for PTEs to reduce their taxable income for the benefit of their members, but it also leads to additional complexity for financial reporting purposes due to the potential accounting for income taxes required under GAAP.
Financial Accounting Considerations
The FASB Codification, Section 740 provides comprehensive guidance on presentation and disclosure requirements for income taxes. Income taxes include both regular federal, state and local taxes on ordinary business income as well as franchise taxes that are based upon a calculated net margin or other methodologies separate from gross receipts taxes.
If income taxes are significant for a non-public entity, this requires additional disclosures around the entity's income taxes paid as well as evaluation of potential deferred taxes and disclosure of the same. These calculations can be very involved for federal and state taxes, although PTE taxes often exclude items that lead to greater complexity at the federal and state levels, such as bonus depreciation or loss carryforwards.
Impact on PTE Taxes
As a result of their intended purpose, PTE taxes fall into a gray area in terms of accounting treatment. In substance, they are taxes paid by the PTE on its net income, but by design are meant to allow individual owners to avoid the individual limit on deducting SALT by paying it at the entity level. Before the SALT deduction was capped, these entities would typically not pay PTE tax and instead pay distributions to the owners for the taxes on pass-through income.
The FASB has not yet clarified treatment of these taxes nor has it proposed any updates to the codification to address this situation. As a result individual companies can use judgment when determining how to present and disclose PTE taxes in their financial statements.
The Two Approaches
The following are some of the key benefits and drawbacks of the two options for accounting for PTE taxes:
ASC 740 (Income Tax) Presentation
Benefits:
- No differences in treatment between the filed tax returns and the financial statements reducing the risk of errors in tax planning. This is especially helpful if tax returns are not prepared by the same firm doing the assurance work.
- Favorable deferred tax positions could improve the Company's balance sheet ratios and liquidity position.
- May be favorable for covenant compliance depending on lender covenants. Distributions may only be permitted for state/federal income taxes and not payment of entity-level PTE taxes.
- For-profit entities subject to HUD compliance may prefer to avoid showing large additional distributions for these taxes if surplus cash is insufficient.
Drawbacks:
- ASC 740 requires significant additional disclosures and analysis that are costly to perform and can be prone to high estimation uncertainty.
- Presenting these payments as an expense reduce net income, which may impact a "no net loss" covenant requirement.
- The reduction in net income also reduces operating cash flow which may be undesirable for covenants
- Due to low statutory rates, PTET taxes are often immaterial and are unlikely to have significant deferred tax assets
Presentation as Distributions
Benefits:
- Presentation is extremely simple, amounts paid for PTE taxes and estimates at the reporting level are classified as distributions. No significant disclosures are made around income taxes.
- Net income is higher with distribution treatment, although it has no net impact on ending equity or EBITDA
- Transactions classified as distributions for book purposes do not need to be distributions for tax purposes, so there is no impact on shareholder or partner basis for tax.
- Distribution treatment shifts the cash outflows to financing activities, improving operating cash flow and related ratios
- Cash paid for income taxes is disclosed under ASC 740, these tax distributions can be disclosed to clarify for lenders or other third-party users.
- No negative impact from deferred tax liabilities
Drawbacks:
- Covenants may permit only certain types of distributions that do not include PTE taxes.
- Treatment produces a book-tax difference that may be missed and may have substantial effects if not communicated to the tax preparer
- No benefit from deferred tax assets
Conclusion
Overall, the simpler approach is to present them as distributions. This eliminates the need to disclose any information related to ASC 740, as well as any additional time and cost required to evaluate deferred tax positions.
PTET laws are complex and vary on a state-by-state basis and making the right decisions for tax and financial reporting can improve operations and save money. Our firm has extensive experience with pass-through entities and their tax and financial reporting requirements, and can assist at any stage in the company's operating cycle. We also have experience reviewing and interpreting loan documents and operating agreements for covenants to ensure the right decisions are made that keep you in compliance.
Please feel free to reach out to me or anyone else on our assurance team at any time if you have questions regarding these pass-through entity taxes or what may be the best approach for your company for US GAAP purposes.
