What You Need to Know about the Wisconsin Entity Level Tax Election and Next Steps
Late in 2018, Wisconsin enacted special tax legislation directed at Pass-Through Entities (PTEs) and their owners. New Wisconsin Act 368 provides Wisconsin PTEs (which covers S Corporations and Partnerships/LLCs) the opportunity to make an annual election to be taxed at the entity level, rather than at the owner or individual level. In some cases, making this election could provide significant tax savings to Wisconsin businesses and their owners, but this election does not necessarily work in all cases. This Sikich Insight will unwrap the new Wisconsin law and address some of the opportunities, drawbacks, transition rules, and other details, along with a useful case study.
Background: What You Need to Know About the New Tax Election
In December of 2017 the Federal government passed Public Law 115-97, better known as the Tax Cuts and Jobs Act (TCJA). TCJA ushered in comprehensive tax changes, including significant revisions in itemized deductions for individuals. Many Wisconsin PTE business owners in prior years claimed the itemized deduction rather than the standard deduction. For these same business owners, the largest itemized deduction tended to be the State and Local Tax deduction (referred to as the “SALT” deduction). Beginning in 2018, the TCJA placed a cap of $10,000 on the amount of state and local taxes that could be deducted as an itemized deduction. This limitation significantly reduced the amount of state income taxes PTE business owners could claim as a deduction. Wisconsin (as well as several other states) then crafted new legislation to permit PTEs to pay and deduct the allocated state income taxes of the PTE owners and thus not be impacted by this new $10,000 SALT limitation.
Therefore, Wisconsin PTE business owners would benefit by deducting the Wisconsin corporate taxes paid on their Federal business tax returns. At the individual level, the business owners then make an adjustment on their Wisconsin individual income tax returns so as not to pay state tax on the same income twice.
Overview of New Law
The new law provides PTEs with the ability to make an annual election, the “Wisconsin Entity Election” (the “Election”), and thus have its income taxed at the entity level. As noted above, this Election is available to both S Corporations and Partnerships in Wisconsin. The effective dates, however, vary for the two.
- S Corporations. For tax years beginning on or after January 1, 2018, a Wisconsin S Corporation may elect to be taxed at the entity level at a tax rate of 7.9 percent on its net income reportable to Wisconsin. To make the Election, the S Corporation must obtain consent from shareholders holding more than 50 percent of the S Corporation shares. The new law does not require this shareholder consent to be submitted to the Wisconsin Department of Revenue (“WDR”) as is done with the federal S Corporation election filed on Form 2553. The Corporation, however, should document the consent of its shareholders in its corporate records.
Partnerships. Partnerships also will be able to make this Election with the same consent of greater than 50 percent, but the Election is not available for partnerships until the 2019 tax year (i.e., tax years beginning on or after January 1, 2019).
If a PTE decides to the make the Election, the PTE income as well as the apportioned income of the PTE is computed as if the Election was not made. Thus, the net income of the PTE will be taxed only once at the entity level and not again at the individual owner level. If the PTE does not make the Election, the net income or loss of a PTE would flow through to the owner and the owner would pay Wisconsin income tax at the individual level. However, as noted above, beginning in 2018 and under the TCJA, the SALT deduction is limited to $10,000 per individual return. Therefore, many profitable Wisconsin PTE owners who decide not to make the Election could potentially lose a significant tax benefit by no longer being able to deduct the full state taxes attributed to the PTE.
There are various provisions related to this new Wisconsin law. PTE owners should consider the following items prior to making this new Election:
The Election is made annually on or before the due date or extended due date of the PTE’s Wisconsin tax return.
To make the Election, persons holding more than 50 percent (shares or capital and profits) must consent to the Election.
If the Election is made, net income of the PTE is taxed at the entity level and only at the entity level, and taxed at a rate of 7.9 percent.
Since all income is taxed at a flat 7.9 percent, if the Election is made, careful consideration must be made if the PTE has any capital gains in the year, as the entity is not allowed the 30% Wisconsin capital gain deduction that individual taxpayers are allowed in Wisconsin.
If the Election is made, the character of the income, losses and other items remains the same. This generally may not present a concern for the PTE in calculating the entity level tax, however, in some situations this could cause difficulty. For instance, if the PTE has owners that are “passive” (under federal Section 469) with respect to the PTE business, this passive treatment could complicate the entity level tax calculation.
The adjusted basis of a shareholder, partner or member is determined as if the Election was not made. Thus, the basis of the PTE is increased for the income of the PTE even though the owner is not taxed on this income.
In the year the Election is made, Net Operating Losses (NOLs) cannot be claimed.
In the year the Election is made, no tax credits may be claimed at the entity level by the PTE other than the credit for taxes paid to other states.
Detailed Analysis Needed
PTE owners of Wisconsin businesses face a difficult decision-making process with this Election. As is often the case, deciding whether to make an election is something done on a case-by-case basis. To make an informed decision regarding the Election, it may be helpful for the PTE business owner to weigh the following items:
- Is the business profitable?
- Does the business currently claim the Wisconsin Manufacturing and Agricultural Credit (“MAC”)?
- Does the business claim other tax credits such as the Wisconsin Research Credit?
- Are there out-of-state members or shareholders with significant ownership in the business?
- Does the business have any significant losses (either current or carryover losses)?
- Will the business have large capital gains in the current tax year?
If the business is profitable, deciding whether to make the Election then focuses upon how the other questions above are answered. For example, the Wisconsin MAC credit is not allowed if the Election is made. Therefore, if the business currently generates and claims the MAC, the PTE owners will need to evaluate how beneficial or significant this tax credit is versus the tax savings that could be realized by making the Election.
Alternatively, if the business generates the Wisconsin Research Credit, the analysis is different, and could impact the decision on whether the Election is made. As noted, unlike the MAC, the Wisconsin Research Credit is not dependent upon the individual taxpayer having a tax liability generated by the taxpayer’s prorated share of PTE income. Thus, the Wisconsin Research Credit from the PTE that is allocated to the PTE owners may offset the individual’s Wisconsin tax liability from other income sources. Therefore, there may be situations where the PTE has Research Credits but could still benefit from making the Wisconsin entity election. Such a scenario should be analyzed on a case-by-case basis.
If the Election is made, the PTE may not claim any Wisconsin tax credits other than the tax credit referenced in Wisconsin Act 368. The PTE may claim a credit for any net income or franchise tax paid to other states as well as any composite tax paid to the other states on behalf of the Wisconsin resident PTE owners. As a reminder when claiming this credit for taxes paid to the states, this credit may not exceed the maximum 7.9 percent tax rate Wisconsin charges on the net income that is taxed by both Wisconsin and the other state.
It is also important to note that if the Election is made, there are additional limitations the business owners must analyze. As noted, if the PTE makes the election, it cannot claim any NOLs. Therefore, if the entity currently has NOLs carrying forward or anticipates incurring an NOL in the current year, it may not make sense to make this Election for the current tax year.
Case Study with the New Wisconsin Entity Election
So, PTE owners might consider making this Election, but would like to first have a better understanding of the potential tax savings. They need to consult with their tax advisor in this process. These savings may best be highlighted through an example. It should be pointed out, however, that different assumptions may yield different outcomes. Depending upon the assumptions, there may be situations where the tax savings are limited or even nonexistent.
For this example, the following assumptions and amounts are provided: the individual PTE owners are in the top federal tax bracket of 37%; the PTE is a qualified trade or business and all income is considered to be generated by a “Qualified Business Income” (QBI) and eligible for the new 20% federal deduction; the net business income of the PTE is $1,000,000; the PTE owners maximize their Federal SALT deduction prior to any income taxes related to the entity; and the PTE is not eligible for any Wisconsin tax credits.
If the PTE does not make the Election, the PTE owners would pay Wisconsin tax totaling $76,500 ($1,000,000 x 7.65%) but would not be able to deduct any of these income taxes on their Federal return (assuming taxpayer is already capped at $10,000 SALT limitation). Therefore, the PTE owners would pay Federal taxes of $296,000 ($1,000,000 x 80% x 37%) and would pay a combined Federal and Wisconsin tax totaling $372,500 [$296,000 + 76,500].
Now, let’s assume the same facts except that the PTE and its owners consent to the Election for their business. In this example, the business would pay Wisconsin taxes at a flat 7.9 percent, which is 0.25 percent higher than the top Wisconsin individual tax rate of 7.65 percent. The PTE, however, would be able to deduct for federal purposes the Wisconsin state taxes it elected to pay with this Election. Thus, the PTE business will pass through to the PTE owners’ federal income of $921,000 ($1,000,000 – $79,000). This pass-through net income, in our example, is all treated as QBI and therefore reduced by the 20% deduction (Section 199A) totaling $184,200 ($921,000 x 20%). The PTE owners in this example will end up with federal taxable income of $736,800 (the PTE income of $921,000 reduced by the QBI deduction of $184,200). This net income of the PTE will now be taxed at the top rate of 37 percent for a total federal tax of $272,616.
Net Impact of Entity Level Election. In this scenario, the combined business and individual Federal and Wisconsin tax paid would be $351,616 ($272,616 Federal tax paid at individual level plus $79,000 Wisconsin tax paid at the entity level). This results in a permanent tax savings of $20,884 ($372,500 versus $351,616). This example illustrates the net tax savings of 2.09 percent ($20,884/$1,000,000) of the PTE’s income.
Next Steps & Resources
As the above example demonstrates, in the right scenario, the savings can be significant. The PTE business owners may find it beneficial to reach out to their tax advisor for further discussion on this topic. Wisconsin based PTE business owners may wish to review Wisconsin Act 368 in more detail. (Please note the IRS plans to issue guidance on this new SALT limitation for pass-through entities. It is uncertain when this IRS guidance will be issued; what the guidance will provide; and when it will be effective. We will continue to monitor these developments – please contact your Sikich advisor with any questions.)
Finally, for S Corporations considering this Election for the 2018 year, the Wisconsin tax forms to make this Election were finalized on July 16, 2019 and therefore can now be submitted to the WDR.
- You may also wish to review Schedule 5S-ET – Entity-Level Tax Computation
- Here also are the instructions for Schedule 5S-ET
The WDR also has numerous documents regarding the Wisconsin Entity Election that you may find helpful. The following includes only a few of many documents Wisconsin has published regarding this topic:
Please contact your Sikich tax advisor if you have any questions or need any assistance.
Tammy Lindvig, Senior Manager, Tax
Tammy uses her expertise to assist closely-held businesses and their owners with their tax planning needs. Through proper tax planning, she guides her clients on how best to achieve their objectives.
Brian Kelley, Managing Director, State & Local Taxes
Brian focuses exclusively on State and Local Taxes (SALT). He had worked seven years with a national accounting firm and nine years with a regional accounting firm before working at Sikich.