86: The PTE Tax Deduction: DON'T MISS OUT!

Welcome everybody to another episode of the Dental Boardroom podcast. The subject of this episode is one that I think every dentist should listen to, who is in a state that has state level income taxes. So I'll just say it straight and clear right now. If you are in Alaska, if you are in Texas, if you are in Florida, or if you are in any state that does not have an income tax, no need to listen to this, it does not apply. However, if you're in a state that does have income tax, and especially if you're in a state that has a high income tax like California or New York, any state that has, let's say, 4 to 5% state level income taxes, or up in California, you're looking closer to 9 to 10% rate. New York's at high as well. This podcast becomes more important, or maybe better said, more relevant for you as a dental practice owner in a high income tax state. So listen up, here we go. Because if you're not doing this, if you're not electing this pass through entity tax, then you are missing out. And that's what this episode is on. It's on this thing called the PTE or Pass through Entity Tax. And I'm going to explain why, what it is, why it matters and how it works, and a little bit of a takeaway of how you make sure that your CPA is including this and giving you proper guidance on it. Because there are some rules now, it's a very low hanging fruit in terms of tax deductions and really good tax deductions. However, it's very easy to miss the basic guidelines around it and then you don't get to take advantage of it. So I hope to clarify this for you so you understand what it is and know how to take matters into your own hand to be able to claim this tax benefit. Okay, I'm Wes Reed, by the way, cpa, cfp, owner of practice cfo, and I work exclusively with dental practice owners to help them run their business effectively as a financial manager of their business. So excited to be here and to share this with you. All right, let's jump into this. What is the PTE or pass through entity tax? As you know, most of you, if you're listening and didn't drop off because your state actually does have its income tax and you're on this with me, then what it is, is it takes that tax payment that you pay to your state income tax body in California. It's called the Franchise Tax Board. Every state is going to have their own sort of name for their tax collecting entity. This is an income tax that you paid at the state level and how you can convert that payment to your state tax body into a tax deduction at the federal level. So I'm going to explain this a little bit more. This relates to your state income taxes. It's paid through your entity, through your, your business entity, not from your personal checking account. And it's designed to bypass this limit on your schedule A of your personal 1040 tax return called the SALT deduction cap. And the SALT deduction cap stands for state and local taxes. And that is going to be your property. For most people it's these two things. It's your property taxes on your home and it is your state income tax payment. And schedule A. When you hear these schedules on your 1040 tax return, these are simply like addendums. The 1040 tax return, really everything, everything cascades into two pages. If you look on your 1040, there's going to be a page where it's going to, it's going to have your name at the top and if you're, if you're married, your spouse's name, assuming you're doing, you're filing jointly with your spouse. And then if you have kids, those kids names will be there at the top and then it will show your income. On page one, you arrive at this number called your adjusted gross income or AGI. It's a kind of a big number in the tax world. We CPAs know this number very well because a lot of other tax benefits are driven or phased out by what your AGI is. But that's page one. And then if you go to page two, it calculates what is the taxes you owe and how much you had withheld from your paycheck or made an estimated tax payments during the year and therefore what's left for you to pay or the refund you get when you really distill it down. The 1040 tax return is pretty straightforward from that perspective. It's two pages. It's not terribly complicated. What makes it complicated is you have a lot of addendums. And some of these addendums are called schedules. And the schedule A is where you get to take certain deductions for personal expenses or personal payments, like paying your property taxes on your home or, or like paying your church for charitable deductions or like paying your home mortgage and getting an interest tax deduction. Now this podcast isn't meant to be a Primer on the 1040. However, a little bit of understanding here on the 1040 will help understand what is this PTE tax. Now, every person who files a tax return, and that's only people who actually owe something. If you don't owe anything, then you actually technically don't have to file a tax return. Now, if you want your refund, well, you do need to file your tax return because that's the only way you're going to get a refund. But everybody who files a 1040 US tax return will have the option of getting one of two deductions. One deduction is called your standard deduction. And this is the government saying you earned income. You filing tax return, you breathe. You're a human. You're a human. And we're going to give you, just by virtue of those things, we're going to give you this free tax deduction against your income. So let's say you get a W2. Keep it simple. You get a W2 and your W2 income is $100,000. And that's all it is in 2025. The free deduction that you get, it's called a standard deduction deduction. And the standard deduction is given to Are you looking to buy or sell a dental practice? 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Anybody to simply reduce the amount of taxes. So in that example, if you had a W2 of 100,000 and you elected this standard deduction 2025, that's 15,000, you're only going to be taxed on $85,000. And you might say, well why is the IRS giving me this free nice deduction? They just do. But then what they also do is they say, hey, we want to incentivize certain behaviors and we'll let you elect a separate type of deduction. And that's called your itemized deductions. And you maybe heard this itemized deduction. Sometimes people say yeah, I itemized on my taxes or I took the standard deduction. You have to choose one of those two things. The standard deduction is $15,000 in 2015 for single and for married filing joint, it is doubled that it's, it's $30,000. So if you have a W2 and a stay at home spouse and your W2 is 100,000 and you file married filing joint, you're going to pay taxes on 30,000. Now I'm simplifying things here, but 100,000 less than $30,000 standard deduction for married filing joint. If you're single taxpayer, you get the $50,000 or if you itemize, then your taxable income will be your W2 of $100,000 less. Your itemized deductions and itemized deductions are the following. Property taxes you pay for your home and estate income taxes. So what you pay to your state for income taxes, but there's a cap there and the cap is $10,000 for both of those interest on your home charitable contributions and there's a few other smaller ones, but those are the big ones. And if those amounts exceed your standard deduction Then you're going to itemize. If the sum of those amounts is $35,000 and you're married and the standard deduction is $30,000, well, clearly you're going to take the $35,000 tax deduction, because then you're only going to pay income taxes on $65,000, where, if you took the standard, you would be paying taxes on 70,000. So the bottom line here is every year you get to choose do I take the standard deduction or do I take the itemized deductions? And you're going to take the larger of the two. And your CPA can help you calculate those simply by looking at your charitable contributions and what's called your 1098, which is the form you get from your bank that loaned money for your house, and it shows you the amount of interest you paid and the property taxes. And then you decide. Now, why I need you to understand that is because it relates to the pte. I want to go back a little bit to the history of the PTE. Why was the PTE tax created so before 2017, on your itemized deductions of your personal return? That's Schedule A, Schedule A itemized deductions, you could deduct. There was no cap, pretty much there was no cap on how much of that state and local taxes you could deduct. So if your property taxes were $8,000 for the year, and then you paid state income taxes of $20,000 for the year, you could deduct the sum of both of those, which is $28,000 for the year. Well, in 2017, the Trump tax code was implemented and it was called the Tax Cuts and Jobs Act. And it was more favorable to states that had lower state income tax and lower housing costs, that is lower property taxes. And it was more painful for people in higher state tax and higher property taxes. Some have argued that that was Donald Trump's way of penalizing states like California and New York, who did not vote for him, because those are the states that suffered the most from the Tax Cuts and Jobs act, which was his tax plan in this area. There are many other changes to the tax code at the time, and some good, some bad, depending on your tax bracket and whatnot. But in terms of this issue of scheduling itemized deductions, where you used to be able to deduct 50, 100,000 plus of your state income tax, plus your property taxes, plus now that got capped to $10,000. Now, many of you, especially if you're in states like California and New York, your property taxes alone are more than $10,000. I know mine are. Now maybe you bought your house 30 years ago and you bought it for so low that your property taxes every year on your house are $5,000. Well, great. That leaves you an extra $5,000 to deduct your state income tax payments. If the cap is 10 and your property taxes are only 5, then you can deduct 5,000 of your state income tax payments. I hope you follow me on that. But for many, if not most people these days who have bought a house anytime in the past 10 to 15 years, your property taxes are probably more than $10,000. Again, that depends on the state. California, it's somewhere around 1% of the property taxes. So if you bought a million dollar home, which basically gets you a very basic home in most of California, then your property taxes are going to eat up that $10,000 cap, which means you do not get a tax deduction, therefore on your payment for your state income taxes. Now remember, this is an individual tax. I'm not talking about any corporate taxes or anything like that. This is your personal taxes. You pay to the state for income taxes. So basically now what you can do, I'm trying to keep this nice and organized as a flow for you to follow me. What happened was a lot of the states like California and like New York said, hey, this new Tax Cuts and jobs act of 2017 has really harmed a lot of our taxpayers in our state because they're no longer getting a tax deduction for making their state tax payments. And let's say you owed $50,000 of state tax payments and you are in a 35% tax bracket. Well, what's $50,000 times 0.535? You just lost out on $17,000, $17,500. Now, I'm going to give a little bit more detailed example and walk through it, but my basic point there is when that TCJA, that Tax Cuts and Job act as 17 went into effect, which I think it went into effect in 2018, when that happened, that scenario right there, where if you lived in California, New York, whatever state you're in, and you paid $50,000 normally to your state income because you maybe you're making some pretty good income, you just lost $17,500 a year of money that now has to go to the irs, that would have been, that would have remained in your pocket because of that schedule a itemized deduction where you could deduct that full $50,000 state tax payment. Well, now you don't get that. And now you have to pay $17,500 more in taxes. And so what a lot of these states did is they said, okay Donald, you really screwed us over here. So what we're going to do is we're going to allow our business owners now we can't do this for everybody, but for our business owners in our state who have what are called flow through entities like an S corp, most dentists are flow through entities like an S corp or partnership, we're going to allow them to pay their state income tax through their corporation's checking account instead of their personal checking account. And by doing that, it's going to, we're going to allow them to deduct that state tax payment in the same way that they would deduct payments for supplies like to Henry Schein or Patterson or Burkhardt. That's a tax deductible. Federal and state. Well, now you get to pay your state income tax. It's going to show up on your profit and loss, your P and L as an expense, and it's going to get deducted on your federal business tax return. Now I'm going to explain a little bit more how then it flows through on the 1040. But I really want you to see that basic overriding concept that before 2017 you would pay your state tax payment out of your personal checking account and you would get to deduct that payment on your schedule A itemized deductions on your 1040 that got capped. No longer could you do it. So the state said, we're going to change the laws here in our own state and now just make sure you pay it through your business. And now you can deduct that against your federal payments. Now the IRS had to think about and they said, whoa, whoa, whoa, are we going to allow.

Businesses in all these states to pay their income tax, their state income tax through their business and get a tax deduction? Well, IRS approval not notice 2020-75 confirms this is deductible at the entity level on the federal tax return. Basically, the IRS is saying, yep, we will give our stamp of approval on this little workaround that you states that got negatively affected by the Tax Cut and Jobs Act. We're going to allow you to do that. And so hence since that point, we have been doing this for all of our clients. It is a standard part of our tax planning. Now what I have found, as I get prospects that come to practice CFO and I look at their tax returns, I realize this very Basic, yet very big tax deduction strategy is being missed by a lot of people. Why? Because CPAs, I love all my counterparts CPAs out there, but we can be notoriously uninvolved. CPAs are historians. So when tax time comes and they're filing your tax returns, if you didn't pay your state income tax through your corporation in the prior year, then it's too late. On March 15, when corporate tax returns are due, you can't say, hey, cpa, did you elect PTE tax? For. For me, the answer is, well, no, I didn't. But it's too late. I can't do anything. Because for most states, you had to have paid a certain amount at a certain date in the year of, not after the year is over when the CPA is prepping the tax return. I think that's why it happens is because CPAs are historians. So you really need somebody who's looking during the year at your finances, at your cash flow, and doing a tax projection and, and giving you guidance on when and how much to pay this PTE tax so you can get that tax benefit after the year is over. Because there's many tax strategies that you no longer can can implement after December 31st. This is why I'm going to do a podcast here soon that has key questions to ask your CPA when you meet with them, to help them be proactive and not reactive. Sometimes you got to sort of force that process proactivity in your cpa. Okay, now let me explain which entities are eligible for this. Now, when I say entities, what I mean is how you're structured as a taxable business. And there's various entity types. There are corporations, and within corporations, there are C and S corporations. If you have more than one owner, generally you're set up as a partnership. If you are an LLC. A lot of states allow LLCs. But keep in mind, you may know this from prior podcasts I've done. The LLC does not exist to the irs. There's no such thing as an LLC tax return. That's just a state designation that determines how your business is protected from legal liability. It's a state designation, but when you go to file your tax return, that LLC has to elect to file as a C corporation. I mean as an S corporation or partnership or sole proprietorship, it has to choose that. And now who's not eligible for this? So S corporations are eligible. C corporations or publicly traded partnerships, better said, are not. So that's obviously. But you're an S corporation. Yes, if you're a C Corporation. Yes. But most dentists should not be C corporations. Now I have so virtually have no C corporations. And when we get a client who comes in who is a C corporation, it's because some great great great grandfather back in the 70s already set who set up their corporation as a C corporation. And it never got changed and passed down from generation to generation. That's, that's the only reason I see C corporations these days. And so I actually don't even know off the top of my head. So I'll ask my, ask my assistant here, Charles aka ChatGPT. Is a C corporation eligible for the PTE tax election? Literally. I've never come across this scenario, but some of you out there might be C Corp, so we should. Yep. Yeah, you know what, the answer is clearly no. You know why? Because this is only eligible for pass through entities. Man. I'm giving you like accounting and tax 201 here. But a pass through entity is an entity that doesn't pay income taxes. Instead it sends the income out on a K1 which lands on your personal tax return and you pay the tax there. C corporations pay taxes and they don't dish out a K1. Now they may dish out dividends and then the individual owner of the stock will pay taxes on the dividends. But flow through entities like S Corporations and partnerships do not pay taxes as a business, they just send it out on that K1. So that's really important here. And it's only flow through entities here that are eligible. So who's not eligible? C Corporations answered that. Big publicly traded partnerships, not relevant here. Sole proprietors are not eligible. And yeah, some of you listening to this are probably a sole proprietor. Now if you're a practice owner and you're collecting more than say 750,000 plus a year, you should definitely be converting to an S corp for many reasons. If you're a sole proprietor, it's probably just because you haven't got proper guidance from your cpa. Plus you don't have the same level of liability protection, let alone some tax savings by setting yourself up as an S corporation. So bottom line there, who's eligible? S corporations and partnerships, which is going to be most of you listening to this podcast. All right, let's, let's talk a little bit more about which states allow it. So now we talk about which entities allow it. Now which states allow it. By the way, if any of you are watching this on YouTube, you can see my screen. If you are not watching it on YouTube, I'm verbally explaining all of this, but just know you can go to our YouTube channel at practice CFO and you can listen to this podcast following along to my PowerPoint slide here. Okay, which states allow it? Well, there's over 30 states that have enacted this. Again, if your state doesn't have a state income tax, then this is entirely irrelevant to you because you don't pay state income taxes. Therefore you don't need to run a state income tax through your business. But examples are California, New York, New Jersey, Illinois, Oregon, Colorado, Georgia, Arizona, Maine, Massachusetts, Utah, Michigan, Wisconsin. Now in Connecticut it's actually mandatory. All the other ones, it's elective and if you don't do it by default, you don't get the benefit. Most are therefore voluntary elections. Now, deadlines vary by state. This is really important. I can't go over all the deadlines by each state. That's why you got to look that up. ChatGPT it or ask your CPA. The deadlines vary by state. Here in California you have to make in the year of by June 15th at least 50% of the amount due or of what you owed in the prior year. So again, you can't wait till after December 31 to decide to make your pass through entity election tax. You got to do it in the year of. And so for 2025, part of the reason why I'm doing this podcast is, is a lot of states, it's somewhere in June, like California, June 15th. Right now it's April 21st. The day I'm doing this, you've got about a month and a half, a little over a month and a half to make sure to pay that tax. Now a lot of times my clients will say I feel like my taxes are going up because this feels like a new tax to me. And I have to remind them, no, it's not a new tax. You are paying your state income tax already before 2017. You are just doing it either as a W2 withholding from your payroll and or you are making a quarterly estimated tax payment. You are paying it and you're still going to pay the same amount to your state. This does not affect how much you pay to your state. It only affects how much you pay federally. The deduction is against your federal income tax and therefore the tax savings is a federal tax savings. And again, I'm going to go through a little example here in more detail in just a moment, but it's critical that you talk with your CPA to ask, does your state have a pte? How do you Elect it. And what are the due dates and how much do you have to make as a payment by those due dates? Each state, by the way, will take this general concept of pte, this general term of pass through entity tax, pte, and they will have their own name for it. And the name is usually going to be the name in the state code, the state law, where the state implemented that law. In California, for example, it's called the AB150 tax. And so I often use those terms anonymously for California clients. PTE and AB 150. But different states are going to have a different name, but it's all under this PTE tax umbrella terminology. All right, how is the pass through entity tax calculated? Here's the way it works is every state has a specific tax rate. Now, state income taxes in reality are tiered, generally speaking, not always, but they're tiered just like the federal tax code is tiered, meaning that if you make the first $30,000, you might be paying at the state level, 3%. The next $30,000 you're paying. On that next tranche, you're paying 6%. And the next 30,000, you're paying 9%. Now, that is a very oversimplified explanation because there's usually more tiers or steps, like on a staircase, and the rate goes up with each new step. Now, an important tax concept here is when you get to that higher tier or that next step, it's not retroactively applying that higher tax rate to all the prior steps. No, it's only applying that higher new tax rate on any income above that step. I hope you follow me on that. So in California, for example, it is 9.3%. Because what the states have to do is they don't use a graduated step like that. They just choose a specific number. And In California that's 9.3%. And another state, it might be 5%. In, in New York, I think it's like 10.3%. And whatever that rate is, that is the amount that you can get as a tax deduction. Let me explain this. The entity pays this tax directly through, and you pay it through the corporation. You get to deduct it on your corporate tax return, and then it creates a credit on your personal tax return to reduce your state income tax. Let's run through an example. Here we go. You're in California and you're an S corporation. Let's say you do $1.3 million gross collections after paying all of your overhead, after paying you after paying your 401 costs after everything. At the bottom line of your P and L, it says net income is $400,000. That's what flows out on your K1 because remember, your S corp doesn't pay tax on the $400,000. Now parenthetically on the side, in very few states like California, they do like to tax what is supposed to be a non taxable entity. They charge 1.5% tax on that 400,000. But most states, you don't pay anything at the entity level. Instead that 400,000 goes on your K1, it comes out on your 1040, it's added to your W2 and you pay tax on the aggregate. So in my example, your K1 is $400,000 before making any PTE tax payment. Now what you have to do is you apply that PTE tax rate per the state governing law on the PTE payment. Now in California again they call it AB150 and it's 9.3%. So it's 9.3% of 400,000. It's 37,200. So you take that 400,000 net income multiplied by the state tax rate that's designated in the law for this new pass through entity thing and it is 37,200. In my example, if your net income was only $100,000 times 9.3%, that's $9,300. Okay? So that's part one of the math is calculating how much you should be paying through your entity as a state tax. So you pay it in California. In my example, $400,000 profit times the 9.3 is 37,200. You make that payment to the state of California Franchise Tax Board, or if you're in New York, you make that payment to the New York tax board. Whatever state you're in, you, you calculate that first number and you write that check and you send it to your state taxes and you do it out of your business checking account. That's critical. If you do it out of your personal checking account, it don't count. It's got to be out of your business checking account or business credit card. If your state allows you to pay with a credit card. Now that 37,200, when you made that payment to your state tax board, it goes on your profit and loss statement in the same way you make a payment to your supplier or your labs or your employees or your CPA, etc. And now it is a 37,200 expense which lowers, therefore federally it lowers your K1 by $37,200. And so if your federal tax rate, your federal marginal tax rate, which is the rate at which your next dollar of income is taxed at, and your next dollar of deduction is deducted at. In other words, on the stair analogy of the stairs being the federal tax code, 10%, 15%, yada yada, all the way up to 37.5%. Whatever stair you're on, and I'm going to say you're on a 35%. That's a very common stare for dentists to be at that as their, as their marginal tax rate, you got to be, if you're married, filing joint, you got to be doing taxable income of over 6 of around 600,000 to get into that next top tier of 37.5%. So 35% is a very common tier. If you're married, filing joint, that's somewhere above 250,000 or so. So 35% is the rate at which you get a tax deduction on that payment you made to your state tax board. So if you made that state tax payment of 37,200 times your deduction rate of 35%, you just saved. And here it is, bottom line, drumroll. You just saved $13,020. And if you didn't make that tax payment through your corporation and you paid it traditionally, as you always did for most of your life as a business owner, you paid it personally or you deducted it out of your payroll on your W2, then you do not get that 13,200. And essentially, you just paid over a thousand dollars a month unnecessarily to the IRS. And there are a lot of tax CPAs who are not proactive enough to make sure you're doing this and doing it right. So, and the way it works mechanically is when you make that payment of 37,200 to the state tax board through your corporation's checking or credit card account or your partnership's checking or credit card account, and you get to now deduct it and you get that deduction. What's happening is it creates a credit at the state level, and that credit then shows up on your state income tax return and it reduces the amount you owe. So that's really important in the way that that credit works. Your CPA will understand all of this. The most important thing you can do is just make sure ask them the simple question, am I electing the pte? And what is my tax benefit? And when do I have to make my payments by and how much. You just got to ask them that. And if they're good, they're going to go and look at all your numbers and they should be able to get back to you pretty quickly on an answer to those numbers. All right, everybody, that is the pass through entity tax. Please make sure you're getting that. It is such a low hanging fruit to get that tax deduction. Unfortunately, I wish it were a new tax deduction, but really all it is is it's trying to recover the longstanding decades longstanding tax deduction that you all had before 2017 that the Trump tax code took away from you. You're just trying to get that back. Without getting that back, you saw most likely an increase in your taxes. Now there were other elements of the Tax Cuts and Jobs act that may have benefited you. Some of the brackets did come down. So this is not a political statement on whether or not that was good or bad for taxpayers. That's going to be dependent on your tax anatomy. But in this one regard of the deductibility of your state income tax on your 1040, that was a clear loss to people in high tax states, income tax states. That's the pte. Hope you followed along. If not perhaps go back. Listen again, reach out to your cpa. Until next time, signing out.