Ohio joins a number of states who have recently passed workarounds for the cap on the federal income tax deduction for state and local taxes. On June 14, 2022, Ohio Gov. Mike DeWine signed Senate Bill 246 (SB 246), which (1) permits pass-through entities1 to elect to pay Ohio tax at the entity level on the pass-through entity’s income apportioned to Ohio and (2) grants pass-through entity owners a refundable credit against their Ohio income tax liability equal to the owner’s proportionate share of the tax paid by the pass-through entity.2
In 2022, electing pass-through entities will be subject to tax at a rate of 5%.3 In subsequent years, the rate will be equal to the business income tax rate under Ohio Revised Code (O.R.C.) § 5747.02 (currently 3%).4
$10,000 Federal Income Tax Deduction for Individuals
Currently, internal revenue code (I.R.C.) § 164 caps the federal individual income tax deduction allowed for state and local taxes (property taxes, state and local income taxes, and sales taxes) paid by a taxpayer at $10,000.5 This deduction is taken after federal adjusted gross income is calculated (i.e., “below the line”) and is only available to taxpayers who elect to itemize their deductions.6 IRS Notice 2020-75 provides that taxes paid by a pass-through entity at the entity level are not subject to this $10,000 limitation and are instead taken into account in computing an owners adjusted gross income.7 Thus, the tax paid at the pass-through entity level reduces the federal adjusted gross income of the owner without being subject to the I.R.C. § 164 limitation, even if they do not itemize.
A pass-through entity may elect to be subject to tax by filing a form with the Tax Commissioner making the election by the deadline to file its return for the taxable year under O.R.C. § 5747.42.8 Pass-through entities eligible for the election generally include partnerships, multi-member limited liability companies (taxed as partnerships), and S corporations, but disregarded entities (such as single member limited liability companies) are not eligible.9 The election only applies to the taxable year for which the election is made and is irrevocable for that tax year.10
Under continuing law, a pass-through entity is required to withhold the income tax due from nonresident investors.11 However, a pass-through entity that makes the election under O.R.C. § 5747.38 to be taxed at the entity level is not required to withhold income tax from nonresidents for the taxable year in which the election is made.12 Furthermore, if the pass-through entity already withheld tax for nonresidents, the amounts paid may be applied to the electing pass-through entities income tax liability.13
An electing pass-through entity must file an estimated tax return and an annual tax return and make estimated payments each quarter (due on the 15th day of the month after the end of each quarter).14 The deadline to file the annual return and pay any additional tax shown due on the return is April 15 following the electing pass-through entity’s taxable year that ends in the preceding calendar year.15 Lastly, electing pass-through entities are entitled to refunds for overpayments and are subject to penalties and interest under continuing law for failure to file returns or pay the tax.
Refundable Income Tax Credit
The income tax credit is available to owners of an electing pass-through entity and is equal to their proportionate share of the tax levied on the electing pass-through entity under O.R.C. § 5747.38.16 The credit must be claimed for the owner’s taxable year that includes the last day of the electing PTE’s taxable year for which the tax was paid.17 Non-resident investors in pass-through entities that have Ohio sourced income should consider filing Ohio income tax returns, even if they are not otherwise required to do so, in order to claim the refundable credit, since the credit will generally result in a refund to a taxpayer who has no other Ohio-based income besides that from an electing pass-through entity.
Beyond these basic requirements, SB 246 requires the Tax Commissioner to adopt rules and regulations to administer the tax on electing pass-through entities.18 If you have any questions about how the election and refundable credit provisions apply to a specific scenario, please contact any of the authors or other attorneys in Taft’s Tax Department.
1O.R.C. § 5733.04(O) defines “pass-through entity” as “a corporation that has made an election under subchapter S of Chapter 1 of Subtitle A of the Internal Revenue Code for its taxable year under that code, or a partnership, limited liability company, or any other person, other than an individual, trust, or estate, if the partnership, limited liability company, or other person is not classified for federal income tax purposes as an association taxed as a corporation.
2SB 246 enacted O.R.C. §5747.38 permitting the election by a pass-through entity and O.R.C. §5747.39 granting the refundable credit to owners.
3O.R.C. § 5747.38(B)(1).
4O.R.C. § 5747.38(B)(2).
5I.R.C. § 164(b)(6) (the $10,000 limitation is currently set to expire on January 1, 2026).
6See IRS Form 1040 Instructions; IRS Form 1040, Schedule A.
7IRS Notice 2020-75, Section 3.02(2)-(4); see also, O.R.C. 5747.38(E).
8O.R.C. § 5747.38(C).
11O.R.C. §§ 5733.41, 5747.41.
13O.R.C. § 5747.43(G).
14O.R.C. § 5747.43(B)(1).
16O.R.C. § 5747.39.
18O.R.C. § 5747.38(F).