Governor Whitmer signed H.B. 5376 on December 20, 2021, enacting a flow-through entity tax for those doing business in Michigan. This legislation was passed as a workaround to the federal $10,000 state and local tax deduction limitation that has frustrated many business owners since it was passed in 2017 as part of the Tax Cuts and Jobs Act.
What is the Michigan Flow-Through Entity Tax and Who is Eligible?
Entities treated as a partnership or S Corporation for federal income tax purposes are eligible to make a three-year election to remit the new entity tax. Disregarded entities, financial institutions, insurance companies and publicly traded partnerships are excluded.
A flow-through can elect to file and pay tax on the income attributable to owners that are individuals, estates, trusts and eligible flow-through entities. Estates and trusts are required to report their share of tax to their beneficiaries. Entities with non-eligible owners, such as a corporate member, elect to file and remit the tax on the portion of the tax base attributable only to its eligible owners. Corporate members will continue to report income from flow-through entities according to part II of the Michigan Income Tax Act.
Flow-Through Entity Considerations
A taxpayer must elect into the flow-through entity tax. The election is irrevocable for three years and must be made through Michigan Treasury Online by the 15th day of the third month of the tax year for which they are making the election. However, for tax year 2021 the election may be made by April 15, 2022.
The return is due on the last day of the third month following the year-end. Entities may obtain a six-month extension. This is noteworthy as after the 2021 tax year the election is due before the return, rather than with the return or extension.
Taxpayers are required to make quarterly tax estimates through Michigan Treasury Online if the liability is expected to exceed $800. The Department has issued guidance indicating that underpayment penalties and interest will be waived for the 2021 tax year if tax is paid before March 31, 2022.
The tax is levied at the same rate as the individual income tax, currently 4.25%.
Tax Base and Apportionment
The tax base is federal taxable income, determined as if the electing entities were C Corporations, without deductions described under IRC section 703(a)(2), which include foreign taxes, charitable contributions and NOLs, subject to specific state modification. These deductions will continue to flow through to the ultimate owners. The state modifications include non-Michigan municipal bond interest, gains and losses from the sale of government bonds, state taxes paid, charitable contributions, guaranteed payments, oil, gas and mineral income, and related expenses, to name a few.
Taxpayers will apportion income using the same provisions applicable to individual income taxpayers, which source sales of tangible personal property based on the customer’s “shipped to” location, services based on cost of performance, and other special apportionment factors in accordance with Part I of the Michigan Income Tax Act.
Individual Taxpayer Considerations
Individuals will be required to report their share of Michigan income received from a flow-through entity on their Michigan 1040. They will receive a credit for their portion of the flow-through entity tax paid on their behalf to offset their personal income tax liability. Any credits that exceed their liability may be refunded. This applies to residents and non-residents.
An electing flow-through entity is required to provide to each owner the amount paid on their behalf. It is important to note that non-electing flow-through entities must now also provide Michigan apportionment to its owners for use on an individual’s personal return. While some flow-through entities historically have provided apportionment information to their members, the Income Tax Act did not previously have a requirement to do so. The Department has indicated it will not create a state specific K-1; rather, it will allow flow-through entities to report necessary information to members by any reasonable method.
Net operating losses flow through to the owners and are unable to be carried to future periods by the electing flow-through entity. An entity within a three-year election must file a zero return for any period in which there is a loss.
Flow-through entities that are part of tiered structures must individually determine if they will make the new Michigan election. Any flow-through entity taxes paid are passed proportionally up to the ultimate owners, as an upper tier flow-through entity cannot apply a flow-through entity tax credit received from its lower tier. Similarly, IRC Section 703(a)(2) adjustments made at electing lower tier entities flow through to the ultimate owners and cannot be used to offset income at an upper flow-through entity electing to file.
However, the income of a non-electing flow-through entity will flow up to and be included in the tax base of an upper tier flow-through owner when the owner elects to file and pay the entity-level tax. Any Michigan losses incurred at a lower tier entity, regardless of whether or not they elect to file, are also included in the business tax base of its members and can offset income at higher tiers.
What Does the New Michigan Flow-Through Entity Tax Mean for Taxpayers?
Michigan’s flow-through entity tax presents new planning opportunities, as well as new complexities and requirements.
The tax allows the entity remitting the Michigan tax a federal tax deduction, effectively working around the $10,000 state and local tax cap deduction imposed at an individual owner’s level. Many of the provisions of Michigan’s flow-through entity tax are similar to other states’ recently enacted entity taxes. However, there are a few notable differences, including the three-year irrevocable election, differing due dates for the election and return filing, calculation of the tax base and the treatment of net operating losses.
While Michigan statute makes reference to taxing flow-through entities as corporations, many of the modifications are more in line with the individual income tax laws. One item to note is the flow-through tax statute does not include the corporate income tax $350,000 gross receipts nexus threshold. Instead, the statute allows any qualifying entity with “substantial nexus” to make the election. The statute also does not allow for the exclusion of foreign sourced income that is afforded under the corporate income tax.
Tiered structures that elect to file will present unique challenges in record keeping and providing owners the appropriate Michigan information, as well as working with Treasury to recognize flow-through entity tax credits pushed to upper owners. Additionally, non-electing entities must provide Michigan apportionment information to their owners, which will need to evaluate this new data and determine how to apply to their Michigan filings/elections.
Informally, the Department has indicated all forms, elections and payments must be filed through Michigan Treasury Online. Registration with the state will be required to make the election and file. For companies that were not previously registered, the state may generate notices for other taxes as well.
Because the enactment date was in late December 2021, many taxpayers may not have made an election decision, let alone a tax payment by December 31. The deductibility of the flow-through tax by the business entity at the federal level will follow the IRC 461 rules. Taxpayers should anticipate working with their tax service providers to document when tax payments must be remitted to be deductible each year elected based on each taxpayer’s facts and circumstances. It is further important for non-resident owners to monitor their home state’s tax laws to determine if the Michigan flow-through tax payments will be allowed as a credit for taxes paid to another state on an owner’s resident return.
Contact Bryan Bays at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.