Stakeholders of “pass-through entities” (PTEs) in Ohio now have a new option when it comes to state and local tax (SALT) deductions. In 2017, the Tax Cuts and Jobs Act established a $10,000 cap on state and local tax deductions known as the “SALT cap.”
However, Ohio has now joined the ranks of numerous states that have established an elective PTE tax. This January, when filing for 2022, Ohio entities may now elect to file using Form IT 4738, which was established in June 2022 via Ohio Senate Bill 246 (S.B. 246).
With Ohio's new PTE entity tax election, PTE owners can avoid the SALT cap by taking this deduction at the entity level.
Now that this option is available, here are five important things to know about Ohio’s elective PTE tax, and how shareholders of Ohio’s pass-through entities can benefit:
1. IT 4738 formalizes and strengthens the SALT Cap workaround.
The idea behind IT 4738 is not new. Previously in Ohio, entities may have taken composite taxes at the entity level (using IT 4708) and “passed through” that credit to the shareholders so they could also claim that credit on their Ohio taxes.
Now they need only file IT 4738. (Take note: entities filing the PTE tax in Ohio for the first time in 2022 MUST send in a separate registration form with any payments being made.)
Simply filing the form formalizes the entity’s election and makes it applicable to all entity shareholders. Additionally, because it is a new form, the state of Ohio will not charge any interest or penalties for underpayment in the first year.
And this isn't new, but any estimated tax payments you've made via forms 1140 or 4708 can be included as specific line items on IT 4738 and applied as payments or credits going forward. You can decide where to apply them.
2. The election is binding to all owners.
Previously, the composite tax was typically filed only for non-residents amongst partners/owners/shareholders who had no other Ohio tax return obligations. With IT 4738, it doesn't matter; once filed, all shareholders are elected to it, and it’s irrevocable for the tax year. Filing the IT 4738 meets Ohio filing requirements for the entity’s non-resident shareholders, as long as they don’t have other Ohio income sources.
3. You can reduce adjusted gross income (AGI), which in turn will reduce taxable income – with a slight delay.
While IT 4738 might be a new form, how taxable income is calculated isn’t changing. PTE tax is a deduction on the entities’ actual income, which then gets passed through to the partners/shareholders. Because the deduction is at the entity level instead of an itemized deduction, the shareholders’ AGI is lowered, and then the itemized/standard deductions are considered.
This means that at the entity level, you can deduct the taxes (without limitation), and that deduction passes out through to the shareholders as reduced taxable income on their Schedule E instead of a limitation tax deduction on their Schedule A (itemized deductions).
As for the "delay" in reducing taxable income — most PTE partners/shareholders are cash basis individuals, meaning they can only take deductions in the year those deductions are paid or reported. (As you know, you file 2022 taxes in 2023.) So, many entities are likely calculating estimated tax through year-end to get those deductions for 2022. For example, if a company pays $50,000 in taxes for 2022, when we file taxes in 2023, we get to take those deductions at the entity level. And because it will be on this new form, it is a “stronger” deduction.
But if entities pay that first tax in 2023 when the forms are filed (likely by the tax deadline of April 15th), then those deductions can only be taken in the year 2023/when filing in 2024. So, remember – if you’re considering Form IT 4738, the tax payments you make in April of 2023 will only have a benefit when filing taxes in 2024 for the tax year 2023.
4. In Ohio, individuals must add back the PTE tax as being paid.
On the Ohio Individual Income Tax Form, you are required to add back any Ohio state entity taxes you took as a deduction at the federal level. The taxpayer will receive a dollar-for-dollar pro-rata tax credit for taxes paid by the entity.
5. The tax rate will change.
The Ohio Department of Taxation reports: for taxable years beginning in 2022, the IT 4738 tax rate is 5%; For taxable years beginning in 2023 and later, the tax rate is equal to the tax rate imposed on taxable business income pursuant to R.C. 5747.02 (A)(4)(a), which is currently 3%.
One more thing to note: while this isn’t a change, it merits a reminder — you can deduct a portion of “bonus” depreciation at the entity level. Even though the forms have changed, the way income is calculated is the same as Form 4708 or Form 1140. 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, a pass-through entity credit line.
Depreciation add-backs and deductions are still allowed, and apportionment is still used. The income will be calculated the way it's always been calculated on the other forms. Remember that calculated income is essentially start income. There are NO individual-related credits allowed — only straight income is considered.
PTEs exist to avoid the double taxation of an initial tax on the corporation, followed by a secondary tax on individual stakeholders. Now with IT 4738, Ohio PTEs can elect to pay their taxes at the entity level. With the points above in mind, stakeholders are now able to circumvent the $10,000 SALT limitation with ease.
Sydney L. Quarm, Tax Supervisor, holds a Master of Accountancy, Taxation from Cleveland State University.