State-level pass-through entity tax (PTET) regimes offer structuring opportunities in M&A transactions involving S corporation targets. PTET regimes have been adopted by a growing number of states as a workaround to the $10,000 limitation imposed on the deductibility of state and local taxes from individuals' federal income tax liability (the SALT Cap) as part of the 2017 federal tax reform (commonly known as the Tax Cuts and Jobs Act).1 The PTET regimes can provide significant tax savings opportunities to sellers of targets treated as S corporations in connection with M&A deals structured as asset sales for income tax purposes, thereby better aligning sellers' after-tax objectives with buyers' traditional preference for inside tax basis step-up.

Acquisitions of businesses are often structured as the acquisition of the equity interests in the target business entities rather than the assets thereof. This practice developed due to various commercial considerations (it could prove very challenging to transfer significant assets, contracts and employees as compared to equity interest of an entity), including the often material incremental income tax costs resulting from the sale of assets by entities treated as corporations for income tax purposes.

Even when transactions are structured as the acquisition of equity interests in targets for corporate purposes, it is sometimes possible for such transactions to be treated as asset acquisitions for federal income tax purposes (Hybrid Treatment). In particular, when a target is treated as an S corporation for federal income tax purposes, certain tax elections and structuring alternatives (discussed below) allow for the flexibility to achieve such Hybrid Treatment. Buyers would typically prefer the transaction to be treated as an asset purchase for income tax purposes because that Hybrid Treatment allows buyers to benefit from the step-up in the inside tax basis of the assets of the target (thereby increasing potential depreciation and amortization deductions). However, such Hybrid Treatment often results in incremental tax costs to the sellers, including by reason of a portion of the gain being subject to tax at the less favorable income tax rates applicable to ordinary income, state-level income taxes and, in certain circumstances, differences between inside and outside basis. As a result, the sellers' willingness to engage in such Hybrid Treatment transactions typically depends on the buyers' agreement to make gross-up payments to cover the sellers' incremental income tax costs (the Gross-up Payment). The buyers' willingness to make Gross-up Payments typically depends on, among other things, the expected amount of cash tax savings as a result of the incremental tax deductions attributable to the step-up in the tax basis of the underlying assets and the total amount of the Gross-up Payment.2 

The acquisition of equity interests of an S corporation target can generally be structured in a manner that would allow for a Hybrid Treatment (i.e., treatment as the acquisition of the underlying assets of such S corporation target) by using one of two alternatives. First, the parties can agree to make certain federal income tax elections (namely, an election under Section 338(h)(10) or Section 336(e)).3 Alternatively, the sellers can engage in reorganization steps with respect to the target that are intended to qualify for tax-free treatment under Section 368(a)(1)(F) (commonly known as an F Reorganization). Under the first alternative (an election under Section 338(h)(10) or Section 336(e)), the sale of the stock of the S corporation is treated for federal income tax purposes as a sale of the underlying assets of the S corporation target. As part of the F Reorganization alternative, sellers would typically contribute the equity interest of the S corporation target into a newly formed holding company, maake an election to treat the S corporation target as a "qualified subchapter S subsidiary" and then convert such entity into a limited liability company (Target LLC).4 Immediately before the purchase, the Target LLC is treated for federal income tax purposes as disregarded from its sole owner (the newly formed holding company). As a result, when the buyer purchases membership interests in Target LLC, the buyer is deemed, for federal income tax purposes, to purchase the assets of Target LLC. While the two alternatives should generally yield the same federal income tax result, the F Reorganization alternative provides better protection to the buyer of securing asset purchase treatment in case the target's status as an S corporation is subsequently challenged by the Internal Revenue Service. In either case, special consideration should be given to the state and local tax treatment of the target for income tax purposes, as several states and localities (including the District of Columbia, Louisiana, New Hampshire and New York City) do not follow federal income tax treatment of S corporations.

In an attempt to alleviate the burden of the SALT Cap on their residents, a growing number of states (mostly those with higher income tax rates, such as California, Massachusetts, New York and New Jersey),5 have enacted PTET regimes. Under a typical PTET regime, rather than having the equity holders of an entity treated as a partnership or an S corporation for applicable state income tax purposes (a Pass-through Entity) pay the tax on the income of such entity on their respective tax returns, such Pass-through Entity can elect instead to pay the state tax on its income at the entity level (the PTET).6 Since the Pass-through Entity (unlike its individual equity owners) is not subject to the SALT Cap, the income allocated to its equity owners with respect to the income from the entity generally reflects deductions for state taxes paid by the entity. For state tax purposes, the equity owners typically are entitled to a credit against their individual state income taxes equal to their share of the PTET.7 When PTET regimes were first introduced, there was some uncertainty whether the Internal Revenue Service would challenge their deductibility for federal income tax purposes. In Notice 2020-75, issued on Nov. 9, 2020, the Internal Revenue Service announced its intention to issue proposed regulations that would generally confirm and clarify the validity of such PTET regimes.

The PTET regimes provide sellers with potentially substantial tax savings in the case of M&A transactions that are treated for income tax purposes as asset sales (as well as actual asset sale transactions). As a result, the amount of a Gross-up Payment required by sellers of S corporations may be significantly reduced (and in certain cases may be eliminated altogether), thereby better aligning sellers' after-tax objectives with buyers' traditional appetite for tax basis step-up. While this may not be the result in every deal, the effect of PTET regimes (as a workaround to the SALT Cap) should be taken into account in determining the desired structure for M&A transactions involving Pass-through Entities, including S corporations.  

Under current law, the SALT Cap is set to expire for taxable years beginning after Jan. 1, 2026. The House of Representatives passed a bill that would extend the SALT Cap from 2025 to 2031.8 The same bill also proposed to increase the SALT Cap from $10,000 to $80,000.9 An increase in the SALT Cap may help reduce its impact on certain individual taxpayers in the ordinary course. However, unless the SALT Cap is eliminated altogether, the benefit of the PTET regimes is expected to remain a very important factor in determining the structuring of M&A transactions involving Pass-through Entities. 


1 See Section 164(b)(5) of the Internal Revenue Code of 1986, as amended (the Code). As currently enacted, the SALT Cap applies with respect to tax years commencing between Jan. 1, 2018, and Dec. 31, 2025.

2 In the case of a corporate target that is not treated as an S corporation, the incremental tax cost of an asset sale (or sale of shares in such corporation with an election for a Hybrid Treatment, in the limited circumstances in which such treatments is possible) is typically far too significant (as compared to the net present value of the cash tax savings) for a buyer to be in a position to pay for it.

3 Unless otherwise explicitly stated, all section references are to the Code.

4 The exact mechanical steps involved in such conversion depend on the corporate laws of the applicable state in which the S corporation target and the Target LLC are organized. Certain states allow for a conversion into a limited liability company through the filing of an articles of conversion (or similar form), while in other states the "conversion" requires a merger of the prior S corporation target into a newly formed limited liability company.

5 The list of states with current PTET regime includes Alabama, Arizona, Arkansas, California, Colorado, Connecticut, Georgia, Idaho, Illinois, Louisiana, Maryland, Massachusetts, Michigan, Minnesota, New York, New Jersey, Oklahoma, Oregon, Rhode Island, South Carolina and Wisconsin.

6 While most PTET regimes enacted to date require an affirmative election into such a regime (e.g., Massachusetts, New York), application of the PTET regime in Connecticut is mandatory.

7 The credit regime varies by state.

8See H.R. 5376, 117th Cong., Rules Cmte. Print 117-18 § 137601 (as passed by the House of Representatives, Nov. 19, 2021).

9 See id. as modified by amendment printed in H. Rept. 117 - 173.

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