On this episode of the Tax Section Odyssey podcast episode, Dave Kirk, National Tax Partner — EY, and Chair of the AICPA’s Pass-through Entity Tax Task Force, discusses the complexities surrounding state tax refunds related to the pass-through entity tax (PTET) and delves into the challenges posed by the lack of IRS guidance, the application of the tax benefit rule and varying state regulations. Dave emphasizes the importance of consistency in handling these refunds and advises practitioners to involve taxpayers in decision-making due to the inherent uncertainties and risks.

AICPA resources

FAQ on the Federal Taxation of State Income Tax Refunds for PTET Payments — FAQ guidance on the federal taxation of state income tax refunds for PTET payments.

AICPA list of taxpayer and practitioner considerations for whether to elect into a state pass-through entity (PTE) tax — Various issues should be considered when deciding whether a taxpayer can, and should, elect into a state PTE tax.

Pass-through Entity (PTE) Taxes States’ Legislation and Tax Authorities’ Information and Guidance — A state-by-state PTE matrix tracking and linking to legislative updates, guidance, as well as other relevant information.

State and Local Tax (SALT) Roadmap and Resource Center — Browse the reference library for the latest guidance and tools to address your state and local tax needs including tax rates, due dates, nexus, PTE tax and more.

Transcript

April Walker: On today's podcast, listen to learn more about how to handle refunds related to the pass-through entity tax.

Hello everyone and welcome to the AICPA's Tax Section Odyssey podcast, where we offer thought leadership on all things tax facing the profession. I'm April Walker, a Lead Manager from the Tax Section and I'm here today with a repeat guest, Dave Kirk. Dave's with National Tax at EY. He is the knower of a lot of things, but specifically today we're going to talk about PTET.

Dave, let's start off with, I think when we chatted before, we talked about pass-through entity tax fun with that, we're delving into a very specific issue related to it. Let's first talk about the challenges. There are so many challenges around this, the lack of guidance around PTET, but today we're going to talk about refunds and there isn't guidance really. How has that impacted our practitioners?

Dave Kirk: First of all, thanks for having me again. Being the leader of the PTET Task Force for the AICPA and having to deal with this for E&Y nationally, I've probably spent 500 hours of my life on this that I'm not getting back. It's just that each state is different. You could probably group states together. It usually requires a case-by-case analysis on how the deduction was taken, when the deduction was taken, and how much money the taxpayer is getting back.

The [IRS] Notice 2020-75 only talked about taking the deduction. There was not one word in that notice talking about refunds. You're right, April, there is no formal guidance from the IRS on PTET refunds. But this is also not the first time in US history where a state government has given money back to a taxpayer. Our federal tax system, as we currently know, it has only been around for 110 years or so. We do have guidance scattered throughout that last century of payments of taxes, deductions for taxes and recoveries. You might call it the common law of refunds that we would use in the absence of anything specific coming out of the government on how to deal with this.

Walker: Tax benefit rule, right? It's been around for a little bit.

Kirk: Yeah. There's two aspects of the tax benefit rule. There's the exclusionary aspect of it, and that's been codified about 40 years ago into Sec. 111 of the code. Then there's also the inclusionary aspect which kind of says, hey, you got a benefit for a payment back in a prior year and you have got that payment returned. That should be something, that should be Sec. 61, gross income. But where the complexity arises is, first of all, you can tell whether something is taxable or not taxable based on whether you got a benefit for it in a prior year.

Okay, great. That's relatively straightforward, and I say relative with some emphasis there. But then you'd go down a very slippery slope really quick once you do determine that a PTET refund is taxable, because then you have to ask yourself, what characteristics does that taxable refund have? That is a morass that I don't think that the government ever really envisioned. I'm not envisioning any sort of guidance coming out of the government within the next 12 months on this.

Walker: The last count, we have 50 states. Like you said, you can group them maybe, but each state was allowed with the IRS notice to develop their own regime which causes all kinds of fun. Which again, we won't get into specifically today.

But like you said, it seems like we could the tax benefit rule and thoughts around that, or how we are going to try to provide some assistance to you with a resource that's been developed. You mentioned that you are the Chair of the AICPA Task Force for PTET. We thank you so much for all the things you do for the AICPA. In doing that, you guys have developed some really helpful FAQs around different nuances, some examples or some summary activities that can happen. Let's provide our listeners with some of the key takeaways from those FAQs.

Kirk: First, states matter, and who's getting the refund matters. If you're an S corp and let's just keep this simple that you have at dentist that owns an S corp. That S corp makes $1 million and it owes PTET at the S corp level of say, $80,000. What you do assuming cash basis and assuming you pay the exact amount of PTET on December 31st, that you can deduct it. Your K-1 line 1 should be $920,000. You are going to get a credit on your local state return of $80,000. In a vacuum, you should not have a state liability equal to or greater than or less than the $80,000. In a perfect world, that's how the system works, and that's probably about as complicated as the system was ever supposed to be in the eyes of the IRS.

But you know that no one ever hits their tax liability at 100 percent. You might hit by 99, 98% or 101 or 102%, but you're never exactly on the dollar. First is the S-corp. If you thought that you owed $80,000 and you made that payment in December of 2023. Cash basis taxpayer, you reduced your K1 income by the $80,000. But when you