This is one of the articles in the KROST Industry Sports & Entertainment Issue, titled “Understanding the Complexities of Tax for Professional Athletes” by Alan Lo. CPA, MAcc & Randall Poe.
Passthrough Entity Tax Credit
The Passthrough Entity Tax Credit, commonly referred to as the State and Local Tax (SALT) cap workaround, was introduced to mitigate the impact of the federal cap on the deduction of state and local taxes under the Tax Cuts and Jobs Act (TCJA) of 2017. The TCJA imposed a $10,000 limit on the deduction of state and local taxes for individual taxpayers. This limit disproportionately affected residents in high-tax states, leading to increased tax liabilities for many business owners.
To address this issue, some states introduced the Passthrough Entity Tax Credit, allowing pass-through entities to be taxed at the entity level instead of the individual level. As a result, the entity avoids the individual SALT cap, and owners of the pass-through entity receive a credit on their personal income tax returns, offsetting their tax liability and reducing their overall tax burden.
To implement the Passthrough Entity Tax Credit, eligible pass-through entities typically need to make an election with their state tax authorities. This election is generally made at the beginning of the tax year and remains in effect for the entire year. The entity then calculates and withholds the appropriate state and local taxes on behalf of its owners based on their distributive share of income.
Benefits of the Passthrough Entity Tax Credit
- Mitigating the SALT Cap Impact – One of the primary benefits of the Passthrough Entity Tax Credit is its ability to mitigate the adverse effects of the SALT cap for business owners in high-tax states. By electing to be taxed at the entity level, owners can still effectively deduct their state and local taxes, reducing their individual tax liability.
- Improved Cash Flow – For owners of pass-through entities, the credit translates to improved cash flow. Since the entity bears the state and local tax burden, owners receive the credit as a refund or carryforward, reducing the amount they owe in taxes.
IRC Section 199A – Qualified Business Income Deduction
The Qualified Business Income (QBI) deduction, also known as the Section 199A deduction, is designed to level the playing field for pass-through businesses concerning the significant corporate tax rate reduction introduced by the TCJA. Under the TCJA, C corporations benefit from a lowered corporate tax rate of 21%, while pass-through entities such as partnerships, S corporations, sole proprietorships, and LLCs, face higher individual income tax rates. The QBI deduction seeks to address this disparity by offering a deduction at the individual level, thereby reducing the effective tax rate for qualified business income.
Eligibility for the QBI Deduction
To be eligible for the QBI deduction, business owners must meet certain criteria:
- Pass-Through Entity – The deduction is available to owners of pass-through entities, which include partnerships, S corporations, sole proprietorships, and some LLCs.
- Qualified Business Income – The deduction is generally applicable to income generated by the business itself, excluding investment income, such as capital gains, dividends, and interest, as well as certain types of specialized income.
- Income Thresholds – The deduction has specific income thresholds beyond which the benefit of the QBI deduction may be limited or phased out. These thresholds are subject to change and should be considered in consultation with a tax advisor.
- Specified Service Trade or Business (SSTB) – For higher-income taxpayers, there are limitations on the QBI deduction if their business is considered a specified service trade or business. These include fields such as law, accounting, health, consulting, and others. The limitations phase out for SSTBs as the taxpayer’s income exceeds certain thresholds.
Calculating the QBI Deduction
The computation of the QBI deduction can be intricate, and it is essential to work with a qualified tax professional to ensure accuracy. In general, the deduction is calculated as follows:
- Determine Qualified Business Income – This involves identifying the business income that qualifies for the deduction and excluding any income that does not meet the QBI criteria.
- Calculate the Deduction – For most eligible taxpayers, the QBI deduction is 20% of the qualified business income. However, as mentioned earlier, certain limitations and phase-outs may apply based on income levels and business type.
Leveraging the Benefits
The QBI deduction presents significant opportunities for tax optimization and savings for eligible business owners. To make the most of this deduction, consider the following strategies:
- Entity Structure – Depending on the business’s unique circumstances, it may be advantageous to choose a specific entity structure that maximizes the QBI deduction, while considering other factors like liability protection and management.
- Wage and Capital Limitations – In some cases, it may be beneficial to adjust the business’s wage and capital structure to optimize the deduction, especially for businesses nearing the threshold for limitations.
- Strategic Tax Planning – Engage in proactive tax planning throughout the year to optimize deductions, expenses, and overall business income, ensuring the greatest benefit from the QBI deduction.
IRC Section 181 – Immediate Expensing of Qualified Production Costs
The Section 181 tax break for film or television productions originated back in 2004 and is currently extended until the end of 2025. Under the current extender, taxpayers can make the election for each production and deduct up to $15 million ($20 million in certain qualified low-income/distressed areas) of qualified production costs for each production as they are incurred. In order to qualify for immediate expensing, IRC Section 181(d) requires at least 75% of the production compensation costs to be incurred within the United States.
Leveraging the Benefits
Rather than deducting the expenses after the release date through amortization, Section 181 is an alternative tool for production companies to minimize the timing difference between production costs and the revenue it generates.
On the other hand, the opportunity to use Section 181 can dramatically change the outlook of an investor’s risk assessment on a film project. The money invested and spent is expensed as incurred and will create a loss that can be passed on to the investor. This could be a considerable tax benefit in the same year when the production begins.
Making the Election
In general, the election must be made by the due date (including any extension) for filing the taxpayer’s federal income tax return for the first taxable year in which the production costs have been incurred. If there are multiple productions that the taxpayer wishes to elect into Section 181 for immediate expensing, the taxpayer must make the election separately for each production.
For each production that Section 181 applies, the taxpayer must attach a statement to the taxpayer’s federal income tax return with the following detail at a minimum:
- The name (or other unique identifying designation) of the production
- The date of the production costs was first incurred for the production
- The amount of aggregate qualified production costs and compensations incurred for the production during the taxable year
- A declaration that the taxpayer reasonably expects that both the production will be a qualified film or television production and the aggregate production costs will not exceed the applicable aggregate production costs limit
For the subsequent years after the initial election, the taxpayer is required to continue reporting the above items as a separately attached statement and update accordingly.
As tax laws and regulations are continually evolving, staying up-to-date and making informed decisions is paramount for achieving tax efficiency and compliance. It is crucial for business owners to consult with qualified tax advisors to understand the eligibility, potential benefits, and implications of the above-mentioned tax strategies for their specific circumstances.
At KROST, we have vast experience in the Sports & Entertainment industry, handling everything from basic accounting and tax services to full-service business and wealth management services. Our firm has the services and expertise needed to assist Sports & Entertainment professionals in maintaining their financial success. If you have any questions, please contact our team of experts for further assistance.
KROST Industry Magazine is a digital publication that highlights some of the hot topics in the accounting and finance industry. Volume 5, Issue 2 highlights some of the hot topics in the sports & entertainment industry, including tax issues for athletes, estate & trust planning, Client Accounting Services, and more.
About the Author
Alan Lo, CPA, MAcc, Manager
Tax, Sports & Entertainment
Alan is a Manager in the tax department at KROST. His areas of expertise include tax planning and compliance for small to medium-sized businesses – sole proprietorships, partnerships, corporations, as well as high-net-worth individuals. He specializes in real estate, sports & entertainment, and professional service industries. » Full Bio