August 31, 2023
We want to bring your attention to a recently signed law that could have significant benefits for many businesses in Iowa. The new legislation introduces changes to the taxation of pass-through entities, including partnerships and S corporations, offering potential tax advantages that you should be aware of.
Overview of the New Law:
The newly enacted law allows pass-through entities (such as partnerships and S corporations) to elect to pay Iowa income tax on behalf of the entity, rather than taxing the income directly to the individual owners. This modification could yield greater tax benefits compared to deducting it as an itemized deduction on individual tax returns.
Background: Entity-Level Taxation vs. Pass-Through Entity Taxation (PTET):
Traditionally, C corporations are subject to entity-level taxation, where the corporation is taxed on its income, and dividends to shareholders are then taxed again. Conversely, S corporations and partnerships are flow-through entities, where the entity’s income is taxed directly to the owners. Distributions from these entities are often not subject to taxation, providing potential tax advantages.
Advantages of the Iowa PTET Law:
The recent legislation signed by Iowa Gov. Kim Reynolds on May 11, 2023, implements PTET retroactively to the start of 2022. Under this law, pass-through entities will pay tax at the highest Iowa rate (8.53% for 2022 and 6% for 2023), with owners then including their share of income on their individual tax returns. Owners can then claim a credit for most of the PTET paid by the entity. If the credit exceeds the owner’s Iowa individual income tax, the excess becomes refundable. For the 2022 year, the credit passed through to the owners will be 91.47% of the tax paid by the entity.
Illustrative Example:
An Iowa S corporation with a sole owner reports $500,000 in profits for 2022. Without the PTET election, at the top Iowa rate of 8.53%, the owner’s tax liability would amount to $42,650. However, due to limitations on state tax deductions on federal individual returns, the actual tax benefit might be minimal.
Opting for PTET allows the $42,650 Iowa tax to be directly deducted from the business income in the year paid. Assuming 2023 income is a similar $500,000, it results in a net taxable income of $457,350. Considering a federal tax rate of 35%, the $42,650 deduction translates to a benefit of $14,928. For 2022 the credit reduction would have the entity paying $3,638 more in Iowa tax than the credit the owners will receive. The net tax savings would be $11,290 before the cost of preparation of the necessary forms.
Anticipated Guidance:
As the Iowa PTET law is relatively recent, Iowa Department of Revenue intends to provide more guidance by early October. Our goal with this letter is to inform you of the change in the Iowa law. We will be reviewing our database and contacting you if it appears that the law change will provide you with a refund large enough to warrant the cost of preparation of the necessary forms. It appears that an entity’s 2022 taxable income will need to be $100,000 or above to meet that criterion. The 2022 entity taxable income, the owner’s estimated 2023 tax bracket, whether the income is subject to self-employment tax, whether the income is eligible for the Qualified Business Income Deduction, plus other considerations, all factor into the net benefit calculation. If we contact you, we will need to know if you expect your 2023 income to be significantly higher or lower than 2022 income.
Feel free to reach out to us with any questions or concerns you may have. Our team is dedicated to helping you make informed financial decisions that maximize your advantages under the evolving tax landscape.
