Election at entity level allows for unrestricted federal deduction on Ohio taxes

Matthew D. Maker, CPA, MT, Director, Barnes Wendling CPAs
A.J. Volpe, Tax Specialist, Barnes Wendling CPAs

With the passage in June of Ohio Senate Bill 246 (Ohio Revised Code 5747.38) qualifying pass-through entities (PTE) can now elect to pay Ohio tax at the entity level versus the investor level.

Previously, investors in an Ohio PTE generally paid Ohio taxes at the investor level which allowed for the maximum $10,000 state and local tax deduction. With passage of this bill, the tax can be paid at the entity level, which allows for an unrestricted federal deduction on Ohio taxes.

SB 246 is considered a state and local tax (SALT) workaround, and Ohio is among nearly 30 other states to have passed such laws in response to the 2017 Tax Cuts and Jobs Act (TCJA), which limits state and local tax deductions to a maximum of $10,000 per taxpayer at the individual level.

Let’s illustrate SB 246 in action

  • A PTE reports $1 million in Ohio taxable income.
  • Assuming a 3% tax rate, the PTE would owe $30,000 in Ohio tax.
  • Investors pay this tax on their personal returns, but TCJA limits the deduction to $10,000 at the federal level.
  • SB 246 allows the entity to pay this tax at the entity level, reducing federal taxable income by $30,000, realizing a $20,000 deduction.
  • Assuming a 37% federal tax rate, this equates to $7,400 of additional tax savings on the investor’s personal tax return.

Important details of this bill include

  • The tax rate at the PTE level is 5% for 2022 and conforms to Ohio business income rates (3%) for 2023 and beyond. The election to be taxed at the entity level is made annually by the entity, is binding for all owners, and irrevocable.
  • Disregarded entities, such as entities reported on a Schedule C, page 1 of Schedule E, and Schedule F, may not elect.
  • Filing the IT 4738 meets Ohio filing requirements for the entity’s non-resident and trust investors unless they have other Ohio sourced income.
  • Owners who file an Ohio individual income tax return (IT 1040) must add back the tax amounts paid on the IT 4738 to the extent not included in computing federal or Ohio adjusted gross income using the Ohio Schedule of Adjustments, line 2.
  • A refundable credit for the proportionate share of the tax paid on the IT 4738 is available for owners who file an IT 1040 using the Ohio Schedule of Credits, Pass-through entity credit line.

How to make this election

The election can be made by filing Form IT 4738, due April 18, 2023. This form is currently in development and will be shared on Ohio’s website as it becomes available.

Estimated tax payments

Currently, there is no estimated payment coupon (UPC) available for the 4738. It is recommended to use the IT 1140 UPC, and any estimated payments made via this UPC can be transferred and applied to the 4738 when the return is filed.

Note that the due dates for estimates are the same as IT 1140 (4/15, 7/15, 10/15, 1/15), which are slightly different than the individual estimated due dates (4/15, 6/15, 9/15, 1/15).

As the third quarter is the first quarter Ohio is offering qualifying PTEs the ability to pay estimates, it is currently unclear how Ohio will treat any underpayment related to the first two quarters of 2022.  Ohio may ultimately waive interest and penalties for the first two quarters but may require 75% of the expected tax to be paid by the third quarter due date of October 15th.

Additionally, Ohio has not provided guidance regarding the possible transfer of investor’s first and second quarter tax payments being transferred to the 4738, however it seems unlikely this will be an option.

Conclusion

With the passage of SB 246, Ohio continues its attempt to remain competitive with other states that have enacted similar SALT workarounds, which results in a win for Ohio taxpayers.

Careful consideration is needed to determine if an election to be taxed at the entity level is right for your pass-through business. Determining the timing and amount of estimated tax payments, especially in the PTE tax’s initial year, may also be critical to controlling cash flow. 

There may also be additional planning regarding entity selection in order to maximize the benefits of SB 246. 

Additional updates will be available on the Ohio Department of Taxation website.

Let us help you with your tax planning. Contact us for more information.

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