MICHIGAN FLOW-THROUGH ENTITY TAX ELECTION
House Bill 5376, enacted on December 20, 2021, by Michigan Governor Whitmer, offers owners of Michigan pass-through entities (e.g., LLCs and S Corporations) a workaround to the state and local tax (“SALT”) deduction limitation enacted by the Tax Cuts and Jobs Act (“TCJA”) for as long as the aforementioned provision is in effect. Michigan is one of sixteen states that have passed law to counteract the federal SALT deduction limitation effective for tax year 2021, six others are effective beginning in tax year 2022, and seven more states are considering the move.
What it means: If a pass-through entity’s owner(s) choose(s) to make the FTE tax election, the business will pay an entity-level tax equal to the net income it will flow through to its owner’s Form 1040 – Sch E multiplied by the Michigan individual income tax rate of 4.25%, which can be deducted by the business on its tax return for the year in which it was paid. The entity owner will be given a credit on their form MI-1040 for the portion of the FTE tax payment allocable to him or her (based on his or her ownership percentage).
What is the Benefit?
As previously alluded to, the TCJA enacted a SALT deduction cap which has proven to be a detrimental provision for individual income taxpayers who itemize deductions on Sch A and incur more than $10K total in state and local income, sales, real estate, and personal property taxes (“SALT”). SALT payments incurred during a calendar year exceeding the $10K cap are nondeductible in the current year and do not carry forward, meaning they are permanently nondeductible. The FTE tax election is a solution to the problem posed by the TCJA SALT deduction limitation because it allows the owner of a flow-through entity to deduct the Michigan individual income taxes imposed on their allocable pass-through income at the entity level, thereby moving the deduction from Sch A to Sch E where it will not be limited unless there are other issues such as at-risk, basis, or passive activity limitations.
For example, XYZ, LLC generated $1M of net pass-through income in 2021 and is owned 50% by John Smith, so $500K will flow through to his individual income tax return. He will incur $21,250 in Michigan individual income taxes which could be deducted on his 2021 Sch A if ample estimated tax payments were made during the 2021 calendar year (otherwise, it would be deductible in 2022), and in addition, he paid $5K in real estate taxes. His SALT deduction is limited to $10K, so $16,250 is permanently non-deductible. His effective tax rate is 37%, so his foregone tax savings is $6,013. If a timely FTE tax election was made in 2021, the $21,250 in Michigan individual income taxes would have been deducted at the entity level and thereby moved off of his Sch A; allowing him to utilize his otherwise nondeductible SALT payments.
Making the FTE tax election is even more beneficial for pass-through owners who take the standard deduction on their federal individual income tax return, as the Michigan individual income taxes imposed on their allocable pass-through income can now be deducted in addition to taking the standard deduction on their personal income tax return. Prior to 2021, a pass-through owner’s allocable Michigan individual income taxes were permanently nondeductible if they took the standard deduction, irrespective of the SALT deduction limitation. This is because individual taxpayers are allowed to deduct the greater of the standard deduction or their itemized deductions (e.g., charitable contributions, medical expenses, mortgage interest, state and local taxes, etc.). Even if some itemized deductions are incurred, it’s more advantageous to take the standard deduction if it’s greater by comparison. However, the FTE election affords passthrough owners the opportunity to reclassify their allocable flow-through Michigan individual income taxes as a business expense rather than an itemized deduction. Thereby creating an above and beyond deduction that would otherwise be foregone.
How it Works:
- To make a timely election for a taxable year, it must be made by the 15th day of the third month of that taxable year.
- The Michigan annual FTE tax return must be filed by the last day of the third month following the end of the entity’s tax year (official form has yet to be released, preview can be viewed here).
- Once the election is made, it’s irrevocable for three years (the tax year the election was made and the following two tax years).
- All payments must be made through the Michigan Treasury Online portal.
- Flow-through entities that make this election must estimate their annual Michigan tax liability.
- If an entity’s liability is reasonably expected to exceed $800, it must make quarterly tax payments.