A recently signed law may benefit many Iowa businesses.
The new law allows pass-through entities (partnerships and S corporations) to pay Iowa income tax instead of taxing the income to entity owners. This results in a greater tax benefit than deducting it as an itemized deduction on individual returns.
As background, the income of a C corporation is taxed to the corporation for federal and state tax purposes, rather than to the shareholders of the corporation. Dividends from a C corporation to the shareholders are taxed to the shareholders. This is often referred to as entity-level taxation.
The income of an S corporation or partnership is taxed to owners of the entity for federal and state purposes. Within limits, distributions from partnerships and S corporations are not subject to tax. This is often referred to as pass-through entity taxation (PTET). Many businesses that are eligible to be taxed as partnerships or S corporations will adopt this pass-through entity taxation to reduce their overall tax liability.
Since 2018, the deduction for state tax on federal individual returns is limited to $10,000, and the individual must itemize to claim that deduction. Due to these limitations, it is typical that the state income tax deduction on a federal individual income tax return results in little federal tax benefit.
To enhance tax benefits, many states have adopted PTET, allowing pass-through entities to pay state income tax instead of individual owners. This deduction directly reduces the entity’s income, resulting in better tax benefits.
On May 11, Iowa Gov. Kim Reynolds signed PTET legislation, applicable retroactively to the beginning of 2022.
The Iowa PTET law provides for the pass-through entity to pay tax at the top Iowa rate (8.53% for 2022 and 6% for 2023). The owners will include the income from the pass-through entity on their individual returns and will claim a credit for their share of the PTET. If the amount of the credit exceeds their Iowa individual income tax, then the excess is refundable to the individual.
Example: An Iowa S corporation, with a single owner, has profits of $500,000 for 2023.
If no PTET election is made and if the income is taxed at the top Iowa rate of 6%, the tax to the single owner would be $30,000 and the itemized deduction for state tax is limited to $10,000. In practice, even that deduction might not result in a tax benefit since the owner may not itemize or may have other taxes to utilize that $10,000 limit.
If the PTET election is made, then the $30,000 Iowa tax is deducted directly from the $500,000 of business income. Then, the net of $470,000 is taxed to the individual. At a top federal tax rate of 37%, the benefit of the $30,000 deduction is $11,100. On the owner’s 2023 Iowa return, they will report the business income and reduce their Iowa tax by the $30,000 credit.
Since the Iowa tax law was signed recently, tax procedures related to PTET are not yet in place. We expect guidance to be issued soon by the Iowa Department of Revenue, but it had not done so as of the date of this column’s submission on June 9.
Regardless, it’s clear that the new law presents an opportunity for many businesses in the state. •
Randolph (Randy) J. Mihm, J.D., CPA, is a tax shareholder at Honkamp, P.C.
