In episode 65 of How Tax Works, Matt Foreman asks the most existential question for a tax practitioner: “What is a tax?”, and in it, he discusses Star Wars, Happy Gilmore, tariffs, the Verrazzano Bridge, New York publication fees, -Cincinnati taxes from the 1950s, and soak-up taxes in an attempt to determine if a PTET is actually a tax. 

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

Whether you’re a seasoned entrepreneur, accountant, lawyer, or financial advisor, How Tax Works offers a wealth of knowledge to empower you in making sound business decisions. Tune in and embark on a journey to unravel the complexities of tax law, one episode at a time.

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Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:07]:
Hello and welcome to the 65th episode of How Tax Works. I’m Matt Foreman. In this episode, I will discuss what is a tax and whether pass-through entity tax payments are correctly deductible under the Internal Revenue Code. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions that we all make. Before we get started, a few administrative things.

Matthew Foreman [00:00:44]:
New episodes in every— new episodes every 2 weeks. The next episode, we’ll talk about Opportunity Zones 2.0. Maybe, maybe. I haven’t, I haven’t totally thought out my next ones. We’re, we’re in November now and I’m recording this at the end of September. So like there’s a lot that could happen here. I may talk about Opportunity Zones 2.0. I may talk about estate and gift taxes in the context of QSBS stacking.

Matthew Foreman [00:01:05]:
I’m also toying with a bunch of other ideas that will eventually happen. So we’ll see how it goes. You know, I think that there’s a bunch that can really go in here. I might talk about, you know, what to expect when you’re selling a business from a tax perspective. That’s always an interesting one. Anyway, so upcoming webinars and speaking engagements. Are on the How Tax Works landing page by the time, which is on the FRB website. By the time you get here, this is like leaving a message in the future.

Matthew Foreman [00:01:32]:
I’m already through one week. There’s another one coming up the next week. But what’s going on here? It’s coming up, it’s actually tomorrow when this will be released. But, you know, I have a series of webinars. They’re free continuing ed, CLE, CPE for CPAs. CPAs and EAs and CLE and CE for CFPs. There we go. Get them all right.

Matthew Foreman [00:01:54]:
On a variety of topics. I’ve discussed them a lot. We already did the pass after you lost one, rule one. I can send you a link to watch it if you want. Won’t get credit, but hey, maybe you’ll learn something which has value. What to expect when you’re selling a business, which is tax and non-tax entity selection, payroll taxes in the era of Sorbonne Capital Partners and KLA now, Opportunity Zones 2.0, QSBS, and finally profits, interest, capital interest, and options. in partnerships and LLCs, tax partnerships, all that fun stuff. So, you know, come, we’ll do it.

Matthew Foreman [00:02:22]:
It’ll be a good time. So I’m at episode 65 and I’ve never discussed, explored, or even pondered what I think is the most existential and possibly, possibly foundational question that I deal with. What is a tax? Maybe you’re just as astute and you know it when you see it. Maybe you’re like me and you wonder what is a tax and what is not. People talk about things and you’re like, well, let’s, let’s, let’s pick it apart, right? A lot of lawyers, especially tax lawyers, spend a lot of their childhood picking apart words and thinking about how stuff is made and doing mechanical things. A lot of, a lot of engineers in tax law. So it’s interesting. But before we get here, the context in which I’m discussing this really matters because the deduction for state and local level individual income taxes is capped.

Matthew Foreman [00:03:09]:
Enter the pass-through entity taxes or PTETs. They’re elective taxes, so are they really taxes? Does that matter? Let’s talk about it. What is a tax, right? Black’s Law Dictionary, 12th edition, 2024. It is a charge, usually monetary, imposed by the government on persons, entities, transactions, or property to yield proper— excuse me, yield public revenue. Congress has authority to impose taxes under the Constitution generally, People say, oh, you know, Congress didn’t initially have the authority to issue taxes. That’s a lie. That is just false and an outright lie. The income taxes had to be apportioned between the states, so each state paid the same amount, which is like, why? It doesn’t even make sense.

Matthew Foreman [00:03:54]:
So they got rid of that. But Congress has been imposing taxes, all kinds of taxes, for the whole time that Congress has existed. So ever since the Constitution was signed, right? So You know, states and localities also have the authority to do taxes under their constitution, under the US federal constitution with limitations, obviously. So the question is, what is a tax, right? Which is, you know, I said it’s existential because I like that word. It makes me feel smart, but it’s kind of an interesting question, right? Income tax is a tax. Estate tax is a tax. Gift tax. Yes.

Matthew Foreman [00:04:25]:
What about sales and use taxes? Yes. What about a fuel excise tax? Well, that’s it. What about a tariff? A tariff is absolutely a tax. The federal government has been imposing tariffs for longer than the Constitution has been signed, right? So that was a way that they raised money. So anyone who says that a tariff is not a tax is either wrong or lying. You decide which. What about a fee to form an entity? I think that the people— oh, that’s a service fee, that’s different. I think that’s a tax.

Matthew Foreman [00:04:51]:
I think it’s a tax. They raise income taxes a bit. States raise income taxes a bit. We’re going to get rid of filing fees. So maybe that’s a way to do it. What about New York State has what’s called a publication requirement? If you have an entity that is taxed as a partnership or anything that has, you know, LLC, LLP, basically anything non-corporate, you have to say, hey, I formed this, here it is, here’s an address, etc. And you have to publish it. I think that’s a tax.

Matthew Foreman [00:05:16]:
I really do. It’s a fee. And people say, oh, it’s not to the government and it doesn’t yield public revenue, but I actually think it’s But I think it’s broader than that because it’s imposed by the government, you know. Does it yield public revenue? No. I mean, it really goes to like a private company that’s going to newspaper or other similar publication. I still think it’s a tax. Toll to cross a bridge? Yep. Gonna talk about that in a bit.

Matthew Foreman [00:05:42]:
And, you know, DMV fees I think are taxes because I don’t really get why there are DMV fees. I think it should be free. I think all you’re doing is making it harder for people to get driver’s licenses. So it’s broad, right? I think we can disagree on what exactly is a tax, but taxes are pretty broad. And at least there’s a debate as to what stuff is. All right. So before we go to the first break, let’s talk about movies. We’re going to go off on a bit of a tangent here.

Matthew Foreman [00:06:08]:
But, you know, let’s roll with it. It’s my podcast, I can do, you know, within reason, whatever I want. So there are a lot of movies that are about tax, or at least, you know, are spurred by tax. People are always like, oh, The Untouchables, because Al Capone was convicted of tax evasion. That movie is not about tax at all. It just has a tax ending, which is how it all works anyway, because there’s only 2 sure things in life, death and taxes, as I understand it. Blues Brothers was spurred by a $5,000 property tax bill, which I always thought was a bit implausible. Because you have to assume the orphanage was a, was a nonprofit, so it shouldn’t be subject to property tax.

Matthew Foreman [00:06:47]:
The Firm by John Grisham. John Grisham. The book is a little more overt on it, but it’s actually a firm that does, at least in the context of the plot, it does tax planning. I think it’s pushing income offshore through the use of offshore trusts. It doesn’t work as well today due to changes in law and information sharing, but the book is much more overt than the movie. I read the book at some some point, I think after the movie came out, but I think I actually read the book before I saw the movie. Movies used to be out for more than a week and a half, you know, back in, back in the ’90s. Happy Gilmore, first off, tremendous film, cinematic brilliance, really just, just, just great work on the part of, um, Adam Sandler.

Matthew Foreman [00:07:29]:
But the issue, what spurs it? And, and it’s kind of funny because it becomes— it’s actually a central plot point is that his grandmother owed money to the IRS, right? And as I point out, and I sort of think about this, is there’s a point where Shooter McGavin buys the house in an open auction for it, which used to exist. The IRS now generally just hires a broker and doesn’t do open auctions like that because that’s a tough way to do it, right? And the IRS agent is there and he’s dressed, you know, he’s wearing like a sport coat or a suit. I’m like, that’s a little— maybe the ’90s were wild and I didn’t know it, but You know, spurred by taxes, right? This is also one, and this is really important in Happy Gilmore. Like, he’s going all around, he’s getting these checks for the money he makes. There’s no 1099 reporting, which there would be. There’s no W-9s. He’s not paying taxes as he goes. He has a sponsorship from Subway.

Matthew Foreman [00:08:21]:
There’s— I mean, this movie is issue-spotting tax, particularly in the state and local context. And they just, you know, I’m not sure it’d be more interesting, but I, you know, you know, Maybe that’s an article sometime, is the taxation of Happy Gilmore, to talk about people who work in a lot of states. However, the single largest movie or movie sets that talk about tax or about really at their core started by tax is Star Wars. And no one in their right mind, at least no one thinks it’s a movie about taxes or a series of movies about taxes, but about tolls and tariffs. And if you don’t believe me, The opening crawl for Star Wars Episode 1: The Phantom Menace says, and I’m now going to read it. Episode, Episode 1: The Phantom Menace. Turmoil has engulfed the Galactic Republic. The taxation of trade routes to outlying star systems is in dispute.

Matthew Foreman [00:09:13]:
Hoping to resolve the matter with a blockade of deadly battleships, the greedy Trade Federation has stopped all ships to the small planet of Naboo. While the Congress of the Republic endlessly debates the alarming chain of events, the Supreme Chancellor has secretly dispatched 2 Jedi Knights, the guardians of peace and justice in the galaxy, to settle the conflict. The tax— the taxation of trade routes, right? They have a blockade to enforce taxes, okay, involving ships, and now that, that they’re trying to get around it. Like, this is crazy. Like, what do we— and Congress is just going to debate about it? Like, All right, here we are, right? You know, I just want to know, like, in this one, like, do we bring back all the characters? You know, the little boy has— I forget that actor’s name. You know, he’s grown up so he can’t play anymore. But Natalie Portman, I guess she could still play it. You know, some of the other adult actors, you know, Ewan McGregor is in it, I believe, if my memory serves me right.

Matthew Foreman [00:10:08]:
But like, if you thought crossing the Verrazano Bridge was expensive, which for those who don’t know, goes from Brooklyn to Staten Island, And it is the only way to drive from Staten Island to anything in New York City unless you go into New Jersey and back. People complain about that, but imagine the taxation of trade routes to outlying star systems, right? That’s, that’s a wild one right there. So let’s get some music in and we’re going to talk about taxes and how they’re deductible and what’s going on. Okay, so taxes are deductible, but why? Section 164 of the Internal Revenue Code: state, local, and foreign income taxes are taxable. It’s 164 and is limited for individuals under 164 as in boy 6. Okay. So I’m not going to go into the limitation, kind of talk about a little later, but basically they’re limited. I think a lot of the people who read, who listen to this are very aware of the mechanics of it.

Matthew Foreman [00:11:42]:
If you’re not and you don’t know that state local taxes are limited, then this is really kind of fascinating to me that you’re listening to this, ’cause I don’t know where we’re going with this. So here we are. So the question is really how are taxes deductible and how do pass-through entity taxes work? I’m going to talk about PTETs. Okay. Pass-through entity taxes are PTETs. New Jersey, for example, calls theirs the BAIT, Business Alternative Income Tax. But the whole thing is kind of set out in Notice 2020-75. It cites Revenue Ruling 58-25, which says that a Cincinnati, Ohio local tax paid by a partnership on the partnership’s net income— excuse me, net profit— is deductible as, you know, is a deduction for the partnership itself.

Matthew Foreman [00:12:28]:
Okay, so that’s the premise. And because any tax imposed upon and paid by a partnership on the net profits of its business in Cincinnati is deductible in computing the partnership’s net income. Right. That’s the idea, because the partnership has to pay it. These taxes like that, they exist a lot. The tax was mandatory. It’s similar to New York City’s UBT, unincorporated business tax, or a host of other mandatory taxes imposed on pass-through entities or even C corporations. Right.

Matthew Foreman [00:12:58]:
You know, why do C corporations get to deduct their taxes? Because the tax is imposed on the C corporation itself, not its shareholders, right? I’m going to talk about also, I’m going to talk about partnerships a lot here. This is actually partnerships or S corporations on their distributive share, same logic. Notice 2020-75 also discussed it, but I’m really just going to talk about partnerships because it’ll be faster to say, and I don’t really like talking about S corporations anyway. So under Public Law 115-97, commonly referred to as the Tax Cuts and Jobs Act, taxes imposed at the entity level still reduce the partnership’s or the S corp’s shareholders’ share of income. They cited H.R. Reporter No. 115-466, 260, Note 172. The Treasury and IRS will issue regs.

Matthew Foreman [00:13:43]:
So the notice says there’ll be regulations, which 6 years later has not happened. So I’m going to put some money on it. I don’t think it’s going to happen. I don’t think it’s ever going to happen because I don’t think you can actually reach regulations that say it for the reason that I’ll talk about here. So let’s talk about it in the broader context of PTATs. First, multiple names. As I said, mostly they’re called pass-through entity taxes. Some of them are called PTEs because it’s a pass-through entity tax.

Matthew Foreman [00:14:14]:
Some states have their own names. Like I said, New Jersey is the Business Alternative Income Tax or BAIT. Connecticut’s PTAT is really interesting. Originally it was mandatory. It is now elective. The whole time there was a little bit of drag on it. So for example, Connecticut’s tax rate is 6.99%, if my memory serves me right. I didn’t look into this, so if it’s higher or lower, whatever, that’s fine, doesn’t matter.

Matthew Foreman [00:14:35]:
I’m giving this example, so, so don’t, you know, and I already told you I’m not giving you legal advice, so here we are. Initially you got like 93% of it as a credit. Now you’re getting 87.5% as a credit. So I think it’s important in this moment to talk how PTETs work. Basically, the business makes an election, the business pays tax, and then the individual owners get a credit on their individual income tax returns in their distributive share of the PTET, in their allocable share of the PTET. So for example, if you own 50% of a partnership and the partnership makes $100, you would— and the partnership pays tax on that. Let’s say the tax rate is 10% of $10. you would get a $5 credit to offset your individual income tax return.

Matthew Foreman [00:15:20]:
That’s how PTATs work. There are a little different rules, and when there’s multi-state rules, it gets really clunky, quirky. I don’t, I don’t know what the right term is, but that’s what happens. I’m not going to go into the multi-state rules, but most states give a credit in full. Connecticut is the exception. And I’m going to say something that people get annoyed when I say, but when I look at this, I sort of wonder why states do it without taking a small haircut because this costs money for states to administer and they’re getting literally zero benefit. And people say, oh, well, they should do it because you shouldn’t increase the taxes. And I’m like, well, the federal government increased the taxes, not the state government.

Matthew Foreman [00:15:57]:
Why is the state government paying, you know, allowing people to get around it? So I don’t know. From a policy perspective, they do it. From a taxpayer perspective, maybe I’m happy that New York State doesn’t do it. Well, probably happy that New York State doesn’t to it. But here we are. But Connecticut is the only one that I’m aware of that takes a haircut. Kind of interesting. PTETs have existed, you know, taxes on passive entities have existed for decades, decades and decades.

Matthew Foreman [00:16:21]:
Why the sudden proliferation? And the answer is, you know, before all the taxes, all the PTETs were mandatory. The Cincinnati tax is referenced in Revenue Ruling 58-25, the New York City UBT, the New York City GST and S corps. New Hampshire has a business enterprise tax or business profits tax. Is California’s $800 fee on every single LLC you have, is that a pass-through entity tax? It’s not based on income, but maybe. I think it’s a tax, as I discussed earlier. So here we are. But now suddenly all the PTETs, or most of the PTETs, I think all of them, at least the ones at issue here, are optional. And if they’re optional, why are they deductible, right? What’s the rationale behind that? And I always sort of say that, you know, there’s sort of an idea, and this goes back to 162 talks about this, the idea of an optional payment should not be deductible, right? So to be deductible under Section 164 and Treasury Regulation 1.164-1, it must be structured to fall on a net gain, right? Which PTATs do.

Matthew Foreman [00:17:24]:
Whole bunch of citations for that. Revenue Ruling 80-121, PLR 8411079. And Trujillo, if I’m pronouncing it right, T-R-U-J-I-L-L-O, 68 Tax Court 670. It might be 620. I can’t read my own handwriting, but, you know, one of them will get you there. You can only deduct a tax if it’s mandatory, and most PTATs, like I said, are elective. And the definition of a tax is really a good one. Revenue rulings, 2 revenue rulings, 57-345 and 70-622, both pretty directly give a definition.

Matthew Foreman [00:17:56]:
They give the exact same definition of a tax, which I’m again going to read. I try to avoid reading, and I apologize for doing so, but I think that the language is important. A tax is an enforced contribution pursuant to legislative authority in the exercise of taxing power, and imposed and collected for the purpose of raising revenue to be used for public or governmental purposes, and not as payment for some special privilege granted or service rendered. Taxes are therefore distinguishable from various other contributions and charges imposed for particular purposes under particular powers or functions of the government. In view of such distinctions, the question whether a particular contribution or charge is to be regarded as a tax depends upon its real nature. So I want to dig up on— dig into that, right? So it’s you’re imposing a tax and the purpose is raising revenue. PTETs, except for Connecticut, are revenue neutral. The optional ones are revenue neutral, so you’re not actually doing it.

Matthew Foreman [00:18:59]:
So the question is, are PTETs tax— actually taxes? I think they’re more analogous to a soak-up tax, which are not creditable. What is a soak-up tax? Soak-up taxes are interesting. If you ever take a class on international tax, you should encounter them. If you have clients that have foreign operations and are looking for or US foreign tax credit. You’ll probably run into them. They still exist. But it is a tax imposed by a country specifically to do what’s called absorb foreign tax credits. And I’ll give you the example.

Matthew Foreman [00:19:32]:
Let’s say a foreign country imposes a 10% tax. However, the US will pose, let’s say, a 15% tax on the same income. A soak-up tax is an optional tax that allows the taxpayer to elect To increase that rate to $15. It allows for a soak-up, right? And you can either— and it does that by saying, look, you’re going to pay $15 either way. Do you want to pay it to Country A or Country B? That’s it. And so there’s no net effect. There’s no adverse, there’s no additive tax on it. And I think that’s really important.

Matthew Foreman [00:20:07]:
So what happens is if there’s a soak-up tax, you can take the foreign tax credit on the non-soak-up amount. And you can either— and then you have the option, you can either not deduct the tax because you— because it’s a tax, it’s non-deductible, or you can just deduct the full amount, right? So the soak-up tax actually becomes a tax drag, and therefore you’re allowed to take it, you’re allowed to deduct it at that point. But the states and cities that impose PTATs don’t disallow the corresponding credit. In fact, They give the credit in full. So there’s no adverse effect to taking and electing into a tax, which normally, if you were to explain— not explain totally how PTATs work, it would be irrational to elect into paying taxes, which is what they’re effectively doing. So the question is, should the federal government allow the deduction? All right, we’re going to bring into the last, last musical break real quick here. Okay, I’m going to come back and, and talk about it. What’s the conclusion? Okay, we’re back.

Matthew Foreman [00:21:52]:
So let’s talk about— let’s conclude what’s going on with PTATs, right? Mandatory entity-level state and local income taxes are absolutely deductible. Mandatory entity-level foreign income taxes are creditable deductible. You can make an election on that. There’s reasons for both. We’re not going to go into it because it’s not relevant and we’re nearing the end anyway. Elective entity-level foreign income taxes are not creditable. They’re deductible, but you can’t take the credit. So it becomes a thing under that schema, under that premise.

Matthew Foreman [00:22:20]:
State taxes, you know, states should not allow a credit at the individual level for PTETs because it’s non-additive. If the states allow it, why should the federal government? Section 162 is a general concept, and I think this is important here, that a deduction must be ordinary and necessary. Electing to pay a tax is not necessary. It’s not. The economic substance doctrine, which is both case law and codified under 77010, is only done— if something is done for only a federal tax benefit and there’s no detriment, there’s no state tax detriment, then it necessarily disallows what you’re doing. So in addition to having issues under 174, or excuse me, 164 in general deductibility. You also, I think, have an economic substance issue here. And I’ve always found that sort of interesting that, you know, I talk about it.

Matthew Foreman [00:23:07]:
I talk about tax pros about stuff. It’s, you know, we talk to each other, right? They’re like, oh, that’s interesting. But no one really likes to hear it because they don’t like the fact that I’m saying, well, we should raise taxes on our clients and ourselves often. So that’s really important. If the PTIN has leakage, like Connecticut, right? It’s about 12.5% leakage. So for about every $100 you pay, you get— you lose about $12.50. For every $100 you pay, you lose $12.50. I think that’s more creditable.

Matthew Foreman [00:23:35]:
You know, maybe, maybe just the leakage part, I don’t know, but the whole thing. But I think it has to be mandatory. I also point out, and this is really important for PTETs, you know, one of the biggest concepts in tax that I like from a policy perspective is the idea of horizontal equity. People who are in the same position pay the same amount of tax. And what PTETs do is they absolutely blast that idea out of the water because what they do is they basically say, if you own a partnership or S corp, you just get to pay lower taxes than someone who just draws W-2 income, which never used to be the case. Did not used to be the case. So I always thought that was kind of interesting, kind of has a problem from a horizontal equity perspective, and that bothers me. I also want to talk about, and this is the final point here, is that S corps, And, you know, S corporations have shareholder salaries, mandatory salaries as reasonable compensation, and partnerships or guaranteed payments.

Matthew Foreman [00:24:24]:
Those are not subject or able to get the benefit of the PTET. So it gives a bigger benefit, a bigger idea, especially for reasonable compensation for shareholders to minimize that. Sometimes it’s better to increase it to get higher 199 cap A, but you can do the math. So you get this weird situation where a tax that may not be valid maybe shouldn’t exist, creates really different tax results for people based on elective type, how much they’re paying themselves. A lot of partnerships after the PTES came out, at least ones that are well managed, are going to adjust their, you know, S corps are going to adjust their reasonable compensation and partnerships are going to adjust their guaranteed payments because you want to minimize that. You want to minimize the guaranteed payment, have more of it passing through, even if it’s the same amount of payroll taxes. But you’re going to maximize it therefore minimize tax by minimizing those, have them based on different factors than a guaranteed payment. All right, well, so that was the 65th episode of How Tax Works.

Matthew Foreman [00:25:23]:
Hope you learned something. I’ll be back in 2 weeks with the Mario Lemieux episode. That’s episode 66, where I’m going to talk about— I’m not really sure, have a bunch of ideas, but we’re— it’s gonna be in the middle of November by this point, so I’ll figure it out. And, you know, hopefully you’ll listen then. Hope you learned something. Hope you enjoyed it. Thank you for listening. Whoa.