The Mississippi Legislature has taken up two bills this session [HB 1668 / SB 3102] intended to correct several technical issues contained in last-year’s pass-through entity (“PTE”) election legislation. See our prior coverage of the original PTE legislation here and here, as well as concerns about estimate payment penalties here.
As of this date, both chambers have passed their respective bills and transferred those bills to the other chamber. While some technical differences exist between the two proposals, they are the result of joint efforts of the Mississippi Society of Certified Public Accountants and the Department of Revenue, and are intended to address the following practical issues:
- Clarifies that any PTE credits that exceed an owner’s income tax liability are refundable or can be taken as a credit carryforward into subsequent tax periods. The original legislation did not expressly address this important practical issue, and the feature should also help preserve the benefit of the rate differences between corporate and individual owners of a PTE. The PTE tax is computed at a flat 5% rate, but in 2022 the state reduced the individual income tax rate by eliminating the 4% tax bracket and enacting scheduled reductions of the top 5% rate to 4% by 2026. Following that rate reduction, an individual owner’s flow-through credit would be based on the 5% PTE tax rate, calculated at the entity level, but their individual liability would have been calculated at the lower 4% rate. If the PTE credit is not refundable, an individual owner could effectively lose the benefit of that earlier rate reduction.
- Removes a potential “double-dipping” scenario. The original legislation stated that income of a PTE is exempt at the owner level, but also provided that the owners receive a credit equal to the taxes paid at the PTE level. A strict reading of that could lead to an unintended double benefit, so the proposed legislation would clarify that the owner includes its share of the PTE income in calculating the owner’s gross Mississippi income tax liability, and then claims the credit for the taxes paid at the entity level. There are differences between the two bills on the specific mechanics of that, but the eventual legislation is expected to ensure that no credits are able to be used twice (once at the PTE level and again at the owner level) and that the calculations function to ensure that non-corporate owners receive the benefit of the lower tax rates applicable to individuals.
- Confirms that the PTE credit is calculated prior to application of any PTE-level tax credits. A concern under the original law was that if it were interpreted that an owner-level credit for tax paid by the PTE is calculated based on the amount of tax paid after the application of PTE-level credits, that might effectively nullify the benefit of the entity-level business credit (such as Ad Valorem or Children’s Promise Credits). The following example helps to illustrate the issue:
- Assume the PTE has $1,000,000 of taxable income, so its initial entity-level income tax liability would be $50,000 (assuming flat 5% rate for model purposes). If it generated and claimed a $50,000 ad valorem tax credit, its net entity-level tax liability would be $0.
- Also assume the PTE has two equal owners. Each owner gets an equal allocation of $500,000 of taxable income but will not receive any credit for tax paid at the PTE level if that credit is based on the PTE’s final tax liability. When the owners compute their separate owner-level tax liabilities, they have $500,000 of income x 5% rate (assuming the maximum corporate rate) resulting in each having a tax liability of $25,000. But each owner’s share of the PTE credit for tax paid at the PTE level is $0, so they have a net $25,000 shortfall and effectively lose the benefit of the entity-level tax credit.
- The House bill’s solution is to allow the PTE credit to be calculated based on the gross entity-level tax determined prior to the application of any business credits at the PTE level. In the above example, each owner could claim a PTE credit of $25,000, fully offsetting the liability associated with that PTE income. The owners also would claim their pro-rata share of the ad valorem tax credit (or any other credits generated at the PTE level), thereby ensuring that they receive the full benefit of the rate differential and the value of those credits.
- On this point, the primary difference between the current House and Senate bills is that the House bill was updated to reflect follow-up discussions with the Department related to what level the business credits would be claimed (i.e., the entity versus owner levels). Those changes have not been incorporated into the Senate bill yet but may be added before final passage.
- Modifies the election process to account for different PTE internal voting requirements. To make or revoke an election, the original legislation required that there be “a vote by or written consent of the members of the governing body of the entity as well as a vote by or written consent of the owners, members, partners or shareholders holding greater than fifty percent (50%) of the voting control of the entity, within the time prescribed in this subsection.” Thus, the approval must be made at two levels even though management decisions may or may not be centralized in a board or other governing body, the vote must pass by a specified threshold that may not be consistent with other voting rights/thresholds provided under an entity’s governance documents, and the votes must take place within a specified period. A strict reading of the statutory election requirement also posed questions whether a simple manager governance structure constitutes a centralized board or “other governing body.” The proposed legislation should accommodate other internal management and voting arrangements.
- Transition language. The House bill provides that the changes shall take effect and be in force from and after January 1, 2023, and shall be applicable to any income tax returns the original due date of which are on or after such date. That should make the technical revisions applicable to the vast majority of PTE returns that would be filed for the 2022 tax year. This language is missing from the Senate bill but may be added during the amendment process.
Estimated Payment Issue Still Unresolved
One important practical issue the current bills do not address is the concern over estimated tax penalties. Under the current scheme, it may be necessary in an election or revocation year to make duplicate estimated payments at both the entity and partner/member level to avoid estimated tax penalties. For example, if an entity is contemplating making the election for the 2022 tax year (due no later than March 15, 2023 for most entities), the PTE should have been making estimated payments throughout 2022 at the entity level to avoid estimated tax penalties even though the owners may have been making their own estimates based on their anticipated flow-through income. Many of those eligible companies, however, still may not have decided whether to make the election and until now did not have the benefit of the full year’s financial results to enable them to quantify any benefits of the election.
The practical problem is that in the event a PTE election is not made, to avoid their own penalties the partners/members should be making their own estimated payments based on the possibility that the PTE income could be taxed at their level and included in their returns as in prior years. It is very unlikely that DOR will “move” estimated payments from an individual account to an entity account to avoid double payment and/or penalties, which means refund claims will be likely at one level or the other once the final filing position is determined and liability is calculated.
DOR previously indicated informally that they will likely waive any penalties that might apply for having failed to make entity-level 2022 Q1 and Q2 estimated payments due to the effective date of the original legislation and the lack of an election mechanism at that time. Penalties related to the failure to make entity-level estimates for Q3 and Q4, however, may be more difficult to abate.
Jones Walker will continue to monitor the progress of this legislation and report out as events further develop.