What’s not to like about ‘pass-through entity’ tax bill?

Photo by Charley Myers

The following commentary was published originally in Honolulu Civil Beat on May 5, 2023.

The Legislature has passed a bill that would lower taxes on Hawaii-based businesses — at no cost to the state government.

It sounds too good to be true, but Senate Bill 1437 would do just that.

In a nutshell, the bill authorizes members of “pass-through entities,” such as partnerships and S corporations to deduct their state income taxes from their federal income taxes.

Partnerships and S corps differ from traditional C corporations in that their members pay taxes on their business incomes only once — at the individual level, not the corporate level.

The bill was proposed in response to a change in federal tax law under the Tax Cuts and Jobs Act of 2017, which put a $10,000 cap on how much state income tax partnerships and S corps could deduct from their federal income taxes.

Until 2017, the law didn’t cap those deductions, so the owners of businesses in states with an income tax could lower how much taxes they owed the federal government by the total amount of their state income tax bill.

For example, say that the owners of Pono’s Poke (a fictional neighborhood grocery store) owed $20,000 in income tax to the federal government and $20,000 to the state of Hawaii.

Until 2017, the store’s owners could have deducted the entire amount of tax they owed to the state, cutting their federal tax liability to zero.

For entrepreneurs in states with unfriendly business climates, this deduction was a boon. But the 2017 Tax Cuts and Jobs Act changed all that.

In response, several states looked for creative ways to help out their local business owners. They discovered that allowing members of passthrough entities to pay taxes at the entity level might avoid the deduction cap.

The IRS OK’d this strategy in 2020, and more than 30 states have enacted a pass-through entity tax law to date.

In technical terms, SB 1437 would permit the owners of Pono’s Poke to pay their state individual income taxes at the entity level. So now the business, not the owners, would be the legal entity paying the tax, and the owners could deduct their state tax burden from what they paid in federal income taxes.

It’s a complicated bill that makes more sense to accountants and lawyers than anyone else, but it would yield appreciable benefits to Hawaii taxpayers by allowing pass-through taxation starting with the 2023 tax year.

The bill will not fix Hawaii’s underlying cost-of-living challenges.

In terms of the magnitude of those benefits, The Wall Street Journal reported last year that business owners in the states with pass-through entity laws have saved more than $10 billion.

In Hawaii, almost 15% of businesses in 2020 were organized as one or the other of these entities and accounted for more than 30% of Hawaii business receipts, according to the state Department of Taxation. So SB1437, if enacted, likely would yield significant benefits to entrepreneurs in Hawaii as well.

Of course, even if signed by Gov. Josh Green, the bill will not fix Hawaii’s underlying cost-of-living challenges. Also, the federal 2017 deduction cap is set to expire in the 2025 tax year, so its benefits might be short-lived, unless the cap is renewed.

But SB 1437 could certainly help Hawaii entrepreneurs at least a little, as well as maybe rehabilitate the state’s reputation as an unfriendly place to do business — currently standing at 46th worst in the nation, according to a 2022 CNBC survey.

And all at no cost to the state?

The only thing left to do is for the governor to sign this bill.


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