Partnership PTET Elections: Deductible Business Expense or Constructive Distribution?

⚡ Advisor-Initiated Medium

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🛡️ Senior Advisor

Good morning. I asked for this meeting because I've been reviewing your partnership's recent state tax footprint, and I think we're leaving real money on the table — potentially six figures a year depending on your income allocation. Here's the issue: your partnership is generating income in seven states, but most of your partners live elsewhere. Under the old rules, those partners were writing p…

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Case Summary ▾

Complexity ⓘ Medium

Fact Pattern Partnership with income in seven states considered electing into pass-through entity tax (PTET) regimes in California, Illinois, and New York to convert non-deductible SALT cap-limited partner payments into deductible entity-level business expenses. Partnership ultimately elected PTET in California and Illinois, claiming $95,000 IRC § 162 deduction for entity-level state tax payments on behalf of nonresident partners.

Position Taken Partnership may deduct state PTET payments as ordinary and necessary business expenses under IRC § 162. Notice 2020-75 explicitly provides that specified income tax payments made by partnerships under state PTET regimes are not subject to the IRC § 164(b)(6) SALT deduction limitation, confirming these are entity-level deductions rather than nondeductible partner payments. California and Illinois PTET elections were recommended over New York due to more manageable compliance requirements and lower penalty risk for estimate underpayments. Implementation cost of $25,000-$35,000 in first year justified by $95,000 federal tax savings (approximately 37% of state tax paid). Phased approach recommended to manage execution risk in first year of PTET adoption.

IRS Challenge Service would likely argue PTET payments constitute constructive distributions followed by nondeductible partner-level tax payments under assignment of income doctrine and Revenue Ruling 75-250, recharacterizing entity deduction as IRC § 164(b)(6) non-deductible partner payment. Examiner position asserts partnership acts merely as paying agent and substance-over-form principles require disallowance despite state-law remittance mechanism. However, examiner acknowledges Notice 2020-75 explicitly excludes PTET payments from § 164(b)(6) limitation, which substantially weakens government's recharacterization theory.

Authorities

IRC § 162 IRC § 164(b)(6) IRC § 6662(a) Treas. Reg. § 1.164-1(a) Notice 2020-75 Revenue Ruling 75-250