Pass-Through Entity State Tax Elections: A Potential Win-Win Structuring Solution in M&A Transactions

Pass-Through Entity State Tax Elections: A Potential Win-Win Structuring Solution in M&A Transactions

October 01, 2024

Key Takeaways:

  • PTE state tax elections may enable buyers to obtain a tax basis step-up without compensating sellers with tax gross-up payments in M&A transactions.
  • TCJA's $10,000 SALT deduction cap led to the creation of PTE elections, allowing state taxes to be paid at the entity level and bypass the cap.
  • PTE elections can align the interests of buyers and sellers in M&A deals by potentially eliminating the need for gross-up payments.
  • PTE elections can create a win-win in M&A transactions by allowing buyers to achieve a tax basis step-up and sellers to receive higher net after-tax proceeds.

The introduction of pass-through entity (“PTE”) state tax elections has dramatically shifted the analysis and negotiations related to tax gross-up payments in basis step-up transactions. This article discusses the implications of the state PTE election for buyers and sellers in M&A transactions, including the potential win-win scenario of providing a buyer with a tax basis step-up without the need to compensate the seller with tax gross-up payments.

Tax Gross-Up Payments in M&A Transactions

The starting point of this analysis centers around most sellers’ primary concern, which is maximizing the after-tax cash proceeds they receive from the sale of their business. Although PTE elections can apply to various pass-through entities, this discussion will focus primarily on S corporations.

The base case structure for an S corporation seller is often a standard stock sale because this generally provides the seller with the highest net after-tax cash proceeds. Typically, a seller will not agree to a different structure if it reduces their net after-tax cash proceeds.

Buyers have historically found themselves in a proverbial Catch-22 when it comes to structuring their transactions for a step-up in tax basis, which can make structure a sticking point in M&A transactions. While there is typically a cash tax benefit to obtaining a step-up in tax basis from increased depreciation and amortization deductions, this does not impact EBITDA, which specifically excludes income tax.

As long as the NPV benefit exceeds the current cost, buyers will often agree to a “gross-up” payment to put sellers in the same net after tax cash position as a straight stock sale. These gross-up payments can be a useful tool in negotiations, helping to align the interests of both parties and facilitate the deal.

Due to recent changes in state tax rules, there may be potential for buyers to achieve a tax basis step-up without the need to pay a gross-up and may provide additional proceeds to the sellers. Enter the PTE election.

PTE Election History

The Tax Cuts and Jobs Act (“TCJA”) enacted in late 2017 brought about significant tax changes for both individuals and businesses. One of the most notable provisions of the TCJA was the introduction of a $10,000 cap on the state and local tax (“SALT”) deduction available to individual taxpayers for tax years 2018 through 2025.1 Before the TCJA, individual taxpayers who itemized their deductions could deduct 100% of state and local taxes paid during the tax year. This limitation does not apply to corporate taxpayers.2

In the wake of the TCJA changes, state legislatures, especially in high-tax burden states, began exploring ways to navigate around the potentially harsh SALT cap limitation. This led to the introduction of the PTE election as a SALT cap workaround, with Connecticut being the first state to enact a PTE election in April 2018 that allowed partnerships and S corporations to pay Connecticut state income taxes at the entity level on behalf of the entity’s owners.3 By imposing the tax at the entity level, the deduction for the state tax expense shifted from the individual owners to the entity itself, thereby creating a state tax deduction at the entity level that is not subject to the $10,000 SALT cap.

After Connecticut's early move, many other states followed suit.4 Furthermore, the IRS released Notice 2020-75, which confirmed the tax treatment of these new “Specified Income Tax Payments.”5 As of April 2024, thirty-six states and New York City allow PTEs to elect to pay income tax at the entity level rather than at the partner or shareholder level.

Requirements for PTE elections differ from state to state. Generally, entities treated as partnerships or S corporations for federal tax purposes can make a PTE election. However, exceptions and limitations exist. For instance, Louisiana prohibits any entity that files a composite partnership return from making the election.6

The PTE election is effective indefinitely in most states, but some limit the election to the tax years in which the federal $10,000 SALT cap applies, 2018 to 2025.7 Once made, the election typically cannot be revoked for that tax year in most states, although exceptions exist. While the entity-level tax election may circumvent the SALT cap, it is not without potential drawbacks.8

Most states provide a 100% credit against their state income tax for their pro rata share of the PTE paid at the entity level. Whether credits carry forward or are refundable varies from state to state. Connecticut, Iowa, Maine and Massachusetts only allow a partially refundable credit against owner taxes.9 There are even circumstances in which the PTE rate can exceed the individual’s state tax rate, providing an excess benefit against other income.10

To illustrate the impact of the PTE election, consider the following example.

  • Example – Ordinary Income without a State PTE Election: S1 is an S corporation located in a state that allows PTE elections, a full PTE credit and taxes ordinary income and capital gains at 5%. S1 has not made a state PTE election. S1 has $1,000,000 of ordinary income. All $1,000,000 flows through to S1’s owner/shareholder, O1, who reports and pays tax on this income on their individual state tax return. At a 5% state tax rate, O1 pays $50,000 in state taxes. However, due to the SALT cap, only $10,000 of this is deductible on O1’s federal income tax return. At an incremental federal tax rate of 37%, O1 pays $366,300 of federal income tax on the $990,000 of net income from S1. O1 receives $583,700 in after-tax cash proceeds after paying $366,300 federal and $50,000 state income taxes.
  • Example - Ordinary Income with a State PTE Election: The facts are the same as above but S1 makes a PTE election. At a 5% tax rate, S1 pays $50,000 in state taxes on behalf of O1, who receives a credit for the full $50,000 of state income taxes paid by S1 and does not have any incremental state income tax liability. The remaining $950,000 flows through to O1 as ordinary income. At an incremental federal tax rate of 37%, O1 pays $351,500 of federal income tax on the $950,000 of income from S1. O1 receives $598,500 in after-tax proceeds after paying $351,500 federal and $50,000 state income taxes. O1 paid $14,800 less of federal income tax due to the state PTE election made for S1.

Tax Structuring for PTEs

Tax structuring is an important component of most acquisitions. Despite their restrictions, S corporations remain a popular entity for closely held small businesses and have been a focal point of founder-owned M&A transactions.11 Although the IRS issued guidance in 2022 providing a streamlined procedure for fixing technical failures with S status, shareholders and buyers are often concerned about the validity of an entity’s S status, especially for businesses with long histories. Depending on the structure of a given deal, the buyer’s step-up in the basis of the acquired company’s assets may depend on the validity of the S election throughout its lifetime. 12

Tax advisors should be consulted early to consider the potential benefits and burdens of structuring alternatives, which will depend on many factors, including issues uncovered in diligence. Broadly, the buyer will either purchase the stock of the company or engage in a basis step-up transaction.

Stock Purchases

In a stock purchase, the shareholders of the target company sell their shares to the buyer. The company continues to operate as before, maintaining its existing tax attributes, Employer Identification Number, contracts, liabilities and legal entity status.

Sellers typically prefer stock sales because they are taxed at the preferential capital gains rate (subject to holding period requirements), rather than the ordinary income rate. A stock sale also allows for a clean break from the business for the seller, as the buyer assumes all of the entity’s historical liabilities.

For buyers, a stock purchase is often simpler than an asset purchase, as it does not require the transfer of individual assets or contracts. Instead, the buyer inherits all the company's contracts, permits, and licenses without the need for third-party consents. The buyer can also potentially benefit from the company's tax attributes, such as net operating losses, which can offset future taxable income. However, these tax attributes may be limited by the rules of Sections 172 and 382.13

Stock purchases also have clear drawbacks for buyers, since the buyer assumes the company's historical known and unknown tax liabilities. This can be especially risky in the case of entities that elected S status after operating as a C corporation, with potential federal and state income tax exposures in addition to any built-in gains within the first five years after conversion. The buyer also inherits the carried over tax basis of the company’s assets, since no step-up is achieved. With the addition of numerous accelerated and bonus depreciation mechanisms within the TCJA, many corporations have minimal tax basis in their assets, resulting in lower depreciation and amortization deductions pose-close.

  • Example – Basic Stock Purchase: S1 is the target of an acquisition. O1’s stock basis is zero. The purchase price offered by the acquiror/purchaser, P1, is $10,000,000. At the federal long-term capital gains rate of 20%, O1 pays $2,000,000 of federal capital gains tax and an additional $500,000 of state tax (5% of $10,000,000). Because O1 has already paid $10,000 or more in state taxes on other income, the additional $500,000 of state tax on the sale of S1 is not deductible to O1. O1 receives $7,500,000 in after-tax cash proceeds on the sale after paying $2,000,000 federal and $500,000 state capital gains taxes.

Step-Up Transactions

In contrast to the carried over basis in a stock purchase, there are three fundamental step-up transaction structures that each provide the buyer with a step-up in tax basis in the target company’s assets:

  1. Asset purchases;
  2. Deemed asset purchases under Section 338(h)(10) and Section 336(e); and
  3. F reorganizations.14

Asset Purchase

In an asset purchase, the buyer purchases individual assets and assumes specified liabilities of the target company. The selling company retains its legal entity status and any assets and liabilities not transferred or assumed in the transaction.

Buyers must allocate the purchase price among the acquired assets to the seven tax classes.15 Some assets generate ordinary income for a seller when the allocated amount exceeds the seller’s tax basis in the asset. This includes cash basis accounts receivable, inventory, depreciation recapture on fixed assets and amortization recapture on Section 197 intangibles. The rate disparity associated with gain treated as ordinary income, rather than capital gain, results in cost differences in asset sales compared to stock sales. Another cost difference driver is that certain states impose entity-level taxes on S corporations. In these states, the gain on the sale is taxable in step-up transactions but not subject to tax in a stock purchase.

Buyers tend to favor asset transactions since they get a step-up in the tax basis of the purchased assets, providing increased depreciation and amortization deductions.16 Buyers can pick and choose which assets to purchase and which liabilities to assume, which lowers the risk of inheriting unknown liabilities. However, transferring individual assets may require third-party consents. Some valuable assets, like certain tax attributes, cannot be transferred in an asset sale.

Deemed asset purchases under Section 338(h)(10) and Section 336(e)

Section 338(h)(10) and Section 336(e) were introduced to provide a tax-efficient mechanism for corporate acquisitions. Section 338(h)(10) and Section 336(e) transactions allow the buyer and seller to treat a stock purchase as an asset purchase solely for tax purposes. The election results in a deemed sale of the target S corporation's assets followed by a deemed liquidation of the S corporation. Just like a standard asset transaction, the buyer achieves a tax basis step-up and the S corporation shareholders recognize gain or loss based on the basis of the assets rather than their stock basis.

These transactions do not allow for tax-free rollover by the sellers and can result in highly tax-inefficient results when earnout payments are considered.17 Additionally, the step-up treatment of Section 338(h)(10) and Section 336(e) transactions for an S corporation relies on the validity of the S status, making this an important point of diligence. Deemed asset sales can also feel onerous to founders and small business owners. Further, Section 338(h)(10) elections are only available if the purchaser is a corporation and the target corporation's shareholders are U.S. taxpayers, among other requirements.

F reorganizations

While the Section 338(h)(10) election was once popular, the most commonly utilized step-up transaction structure for S corporation targets is now the F reorganization, which has key differences from the Section 338(h)(10) transaction.

In this transaction, the target shareholders transfer their stock to a new S corporation holding company (“Newco”) in exchange for Newco's stock. Newco then elects to treat the target as a QSub and converts it into a state law LLC. This process transforms the target S corporation into a new entity under the same ownership, which can then be acquired by the buyer.

The F Reorganization allows the S corporation to maintain its pass-through tax status and offers a solution for potential buyers who have concerns about the target’s S corporation status. Whereas the Section 338(h)(10) transaction requires a valid S corporation to achieve a tax basis step-up, the buyer in an F Reorganization obtains the step-up regardless of S corporation status. Like other step-up transactions, and due to the incremental taxes to the seller, sellers will often require a gross-up payment for transactions structured as F reorganizations.

  • Example – Step-Up Transaction and Gross-Up Payment: S1 is the target of an acquisition. Stock and asset tax basis are zero. S1’s only tangible asset is $1,000,000 of fixed assets. The purchase price offered by the acquiror/purchaser, P1, is $10,000,000. However, P1 would like the transaction to be structured to provide a step-up in the tax basis in the assets of S1. The depreciation recapture on the $1,000,000 of fixed assets would be ordinary income to O1 on the sale of S1’s assets while the remaining $9,000,000 is allocated to goodwill and taxed at capital gain rates. At the federal long-term capital gains rate of 20%, O1 pays $1,800,000 of federal capital gains tax (20% of $9,000,000), $370,000 of federal income tax (37% of $1,000,000 of depreciation recapture and an additional $500,000 of state tax (5% of $10,000,000). Because O1 has already paid $10,000 or more in state taxes, the additional $500,000 of state tax on the sale of S1 is not deductible to O1. Without a gross-up, O1 receives $7,330,000 in after-tax cash proceeds after paying $2,170,000 federal and $500,000 state capital gains and income taxes. O1 requires P1 to make a gross-up payment of $226,667 to arrive at the same after-tax proceeds as a stock transaction.18 With a gross-up of $226,667, O1 receives $7,500,000 in after-tax cash proceeds after paying $2,215,333 federal and $511,333 state capital gains and income taxes. P1 consults with a tax advisor and determines that the benefit of the step up is worth more than $226,667 and agrees to pay $10,226,667 in exchange for the assets of S1.

Typically, due to the value of a step-up in tax basis to buyers and the additional taxes to sellers, transaction structure has been a clear point of negotiations. Each party seeks to maximize their own after-tax profits through different structures or gross-up payments. However, PTE elections may offer a solution that maximizes after-tax cash for both buyers and sellers in a step-up transaction.

State complexities also affect the choice of step-up transaction. For example, New York City, which does not recognize S corporation status, taxes proceeds from the sale of an S corporation through an F reorganization, but not in a deemed asset sale under Section 338(h)(10). In any jurisdiction, buyers and their tax advisors should closely examine current SALT regulations and their interaction with federal tax treatment before moving forward with a transaction structure.

The Win-Win Scenario

While buyers have paid sellers a gross-up for the extra seller taxes in step-up transactions, the PTE election may avoid the need for a buyer gross-up and result in more net after-tax cash for the sellers.

  • Example – Step-Up Transaction with a PTE Election: S1 is the target of an acquisition and now makes a PTE election. S1 is located in a state that allows PTE elections, a full PTE credit and taxes ordinary income and capital gains at 5%. Assume that S1 is eligible and can make the state PTE election in a timely fashion. Stock and asset tax basis are zero. S1’s only tangible asset is $1,000,000 of fixed assets. The purchase price offered by the acquiror/purchaser, P1, is $10,000,000. However, P1 would like the transaction to be structured to provide a step-up in the tax basis in the assets of S1. S1 pays $500,000 of entity-level state taxes (5% of $10,000,000). Because S1 pays the state PTE at the entity level, the full $500,000 is deductible against federal income. S1 has the same $1,000,000 of fixed assets with no tax basis. Therefore, the depreciation recapture on that $1,000,000 would be ordinary income to O1 on the sale of S1’s assets while the remaining $9,000,000 is allocated to goodwill and taxed as capital gains. At the federal long-term capital gains rate of 20%, O1 pays $1,800,000 of federal capital gains tax (20% of $9,000,000) and $185,000 of federal income tax (37% of $500,000). Without a gross-up, O1 receives $7,515,000 in after-tax cash proceeds after paying $1,985,000 of federal income and capital gains tax and S1 paying $500,000 state PTE tax. Now, not only does O1 have $15,000 of additional after-tax proceeds over the stock transaction described in the Basic Stock Purchase example, but P1 is not required to pay the $226,667 gross-up amount in the Step-up Transaction and Gross-Up Payment example, while still receiving the same tax basis step up. By making the PTE election in combination with a step-up transaction, P1 achieves the same tax basis step-up desired by the previous buyers, but O1 also receives additional after-tax cash proceeds.

Summary

The state PTE election creates a win-win scenario both by providing a buyer with a tax basis step-up without paying a gross-up to the seller and also potentially providing a seller with higher net after tax proceeds. Because these PTE elections can benefit both buyer and seller, they have significantly influenced negotiation terms since their implementation.

While there are current discussions to make the changes permanent, the federal limit on SALT deductions is set to expire at the end of 2025 with the sunsetting of many TCJA changes. However, a Tax Foundation study determined that preserving these TCJA tax cuts would cost the federal government $3.5 to $4 trillion over the next decade.19 Some states have automatic mechanisms in place to repeal the PTE election once the SALT deduction cap expires. This likely points to the fact PTE structuring may not be available past 2025.


All section references are to the Internal Revenue Code of 1986, as amended, unless otherwise specified. IRC § 164(a); IRC § 164(b). State and local taxes include income, sales, and property taxes.

IRC § 164(b)(6).

Conn. Gen. Stat. 12-699(a)

Initial attempts by states to create charitable deductions for state taxes were invalidated through amendments to Treas. Reg. 1.170A-1(h)(3).

See Notice 2020-75.

La. Rev. Stat. Ann. 61:1:1001(B)(4).

California, Colorado, Illinois, Oregon and Virginia PTE elections all expire after calendar year 2025.

The tax rates applied and the tax base calculation rules differ significantly from state to state, in addition to the treatment of the owners of PTEs, adding complexity to the process. While certain states, like Arizona, allow owners to individually opt-out of the PTE election, most require the participation of all qualified owners. Ariz. Rev. Stat. Ann. § 43-1014(D).

Connecticut allows a refundable credit of 87.5%, Iowa allows a refundable credit up to 94% of PTE and Massachusetts and Maine allow a refundable credit of 90% of PTE.

10 For example, New York’s highest PTE rate of 10.9% can exceed the rate for an owner filing a joint return.

11 See 26 U.S. Code § 1361 for definitions and requirements.

12 See Rev. Proc. 2022-19, also Rev. Proc. 2013-30 and Rev. Proc. 2004-35.

13 Section 172(a); Section 382(a)

14 See Treas. Reg. 1.368-2(m)(3)(ii)

15 Treas. Reg. 1.338-6.

16 This is subject to certain exemptions, including anti-churning rules. The anti-churning rules can be triggered when seller rollover exceeds 20% and goodwill and/or going concern value existed prior to August 1993. When the anti-churning rules apply, goodwill, going concern value and certain other intangibles cannot be amortized for income tax purposes.

17 See IRC Section 453 for installment sale rules. Taken in a Section 338(h)(10) transaction, this may result in the recognition of the gain on the entire purchase price, including the maximum earnout payments, only to be offset by future capital losses of any difference. Because capital losses are not carried back, this results in an unacceptable tax-inefficiency.

18 Gross-up payments are typically iterative. If O1 received a gross-up of just $170,000 (the difference in after-tax cash in the Basic Stock Purchase example and an asset sale without gross-up in this example), the additional gross-up amount would also be taxed, resulting in $7,457,000 of after-tax proceeds and still falling short if the $7,500,000 of after-tax proceeds in the Basic Stock Purchase. Hence the higher gross-up amount of $226,667 used in this example.

19 https://taxfoundation.org/research/all/federal/2025-tax-reform-options-tax-cuts-and-jobs-act/

Originally published in Practical Tax Strategies