October 15 Deadline for NY State Pass-Through Entity Tax Annual Election Can Save You Up to 40.8%

New York, NY — September 2, 2021

New York State Pass-Through Entity Tax can save you up to 40.8% on every dollar of New York Tax Paid on Your Business Earnings 

For the past several years New York has been spotlighted for directly and indirectly raising taxes on individuals and businesses in an effort to close the budget gaps.  However,  this year New York enacted one of the largest tax cuts in the nation for partners and shareholders in pass-through entities – compliments of the federal government.  The New York Pass through Entity Tax ("PTET") allows the business to pay the individual partner/shareholders' New York tax at the entity level and offers a payment offset against the partner/shareholders' New York liability.  Payment of the tax at the entity level allows for a deduction of the tax against the business income, which may be worth almost double the New York state tax in pre-tax income. 

This  ability to obtain a business deduction for personal taxes will cut the individual partner/ shareholders' tax rates by up to 40.8 percent.

• New York joins its neighboring states of Connecticut and New Jersey in enacting a PTET which enacted similar provisions in 2018 and 2020 respectively. The NY PTET provides individuals a full payment credit of the entity level tax against the individual's personal income tax liability (in contrast CT which limits the credit to 87.5%). In calculating the NY PTET, the apportionment used is consistent with that on which the partner/shareholder's individual tax is calculated, i.e. three-factor formula for partnerships and single sales factor for S-Corporations. (This contrasts with NJ, which imposes a three-factor apportionment for calculating the PTET vs. a single sales factor in determining the partner's income allocable to NJ; the NJ methodology can have a distortive effect on the payments of tax versus the liability of the individual partner). The NY PTET is elected by the entity annually (CT's PTET is mandatory).

• The ability to deduct the Pass Through Entity Tax (PTET) is far better than restoring the itemized deduction as it allows the tax to fully reduce the Medicare Tax of 2.9% on Partnership Earnings from Self-employment and to reduce the Medicare and/or Net Investment Income Taxes of 3.8% where applicable. Moreover, it is not subject to the phaseout of the itemized deduction or the disallowed state and local deduction of the Alternative Minimum Tax (AMT).

WHAT WE KNOW

• The NY PTET is paid in quarterly beginning March 15th of the year. The election is made annually on March 15th of that year. It can be made by any partnership and S-Corp doing business (i.e. nexus) in New York. It can also be made by partnerships that are not doing business in NY but have NY resident partners.Partnerships not doing business in NY but with significant NY partners should consider electing in order to reduce the tax burden of their NY Partners.

  • For 2021, the NY PTET election must be made by October 15th. 

    • For Estimated Tax Purposes NY has stated that the PTET installment payments will not count towards the payment of estimated tax installments; accordingly, the individual taxpayers will need to decide whether to make estimated tax payments in order to avoid the underpayment penalty (i.e. interest) of 7.5% on the quarterly intstallments ( a small price to pay).

    • No payments are due until March 15, 2022; however, in order for the individual to avail themselves of the deduction for payment of the taxes in the current year, any cash basis entity must pay its PTET no later than December 31st .  Accrual method taxpayers can rely on the recurring item exception.

  • In determining the PTET payments for New York resident and non-resident partners:

    • Partnerships/LLCs taxed as partnerships - the PTET paid in with respect to NY resident partners is based on their distributive share of NY Entire Net Income (Federal taxable income +/- NY modifications).  The PTET paid in with respect to NY nonresident partners is based on their distributive share of NY-sourced income.

    • S Corporations -  the PTET paid in with respect to both resident and non-resident shareholders is based on their distributive share of NY-sourced income.  This could create a shortfall with respect to resident partners to the extent the non-NY-sourced income is not taxable elsewhere or a credit for the tax is not available from that jurisdiction.

    •  The reason for the differing treatments is that partners can have distributions that vary from their ownership percentages whereas S-corporations can only make distributions proportionate to ownership in the corporation. 

WHAT WE DON'T KNOW 

• New York allows residents to claim credits for bottom-line personal income tax liabilities to other states.

  • Does it make a difference whether the other state defines a PTET as a credit against the personal tax liability (e.g. CT) or as a payment against the personal tax liability (e.g. NY)? 

• It is not clear how the payments for multi-tiered pass-through entities will work.  It appears that each entity is responsible for payment of the tax on its individual (including estate and trust) partners/ shareholders; however the lower-tier passthrough will still need to provide the upper-tier passthrough with the distribution and data to remit and report the passthrough tax on a quarterly and annual basis.

• At its core, the PTET is deductible as part of the business income from the flow-through. 

  • Does/should the partner/shareholder have to recognize the overpayment or refund under a Tax Benefit Concept? 

  • If the individual pays non-deductible taxes directly and also has payments and deductions of  the PTET?  How is the taxable refund determined?

• It is not clear that investment passthroughs  will benefit by participating in the PTET program.  Generally, investment related expense are no longer deductible as an itemized deduction.  (Prior to 2018, they were deductible to the extent in excess of two percent of AGI.)   

OBSERVATIONS 

• The New York PTET only applies to New York State Personal Tax. 

  • New York City has an Unincorporated Business Tax of 4 percent that it imposes on LLCs, Partnerships and Sole Proprietorships. 

  •  New York City generally imposes a Corporate Level Tax on Subchapter-S corporations at the higher  of 8.85% of apportioned taxable income or 1.3275% of apportioned income with an addback of salaries paid to corporate shareholders 

  • NYC resident partners and shareholders are subject to a personal tax on their distributable earnings of 3.876%. It offers a non-refundable credit of 23% on the personal tax imposed on NYC residents but no offsetting credit for the tax on S-Corporations.  

  • There is no PTET that offsets New York City Entity level taxes already in place.  

• Passthrough entities doing business in multiple states will need to decide the benefit of electing the PTET vs the administrative burden.  Furthermore, passthroughs with partners/shareholders resident in other states need to determine whether the PTET is more costly than paying the tax at the ultimate partner/shareholder level with no deduction for the state tax. 

• Historically most states have not offered a credit for other state's entity level taxes imposed on a passthrough entity; the Texas Franchise tax and the Ohio CAT are two examples of entity level taxes with no credit against most state personal taxes.  Accordingly taxpayers are not  automatically assured of a credit against the state's personal income tax for the PTET imposed by the other state.  California for example, does not currently allow for a credit against its personal income tax.  (CA has proposed legislation for a PTET.)  

  • A credit of the PTET against the personal income tax imposed by  another state is a dollar-for-dollar benefit against their resident tax liability.  The ability to deduct the tax will generate a deduction of up to 40.8% of the states PTET tax. On $1,000 of income, the NY PTET would be $109 which will offset the individual's New York personal income tax.  The individual will also benefit from a deduction of $44.47, equaling 40.8% of the tax. The net tax is therefore $64.53.

• The CA resident tax on the same income is $133  If the tax is paid at the individual level it can offset the CA tax in full.  If however the PTET is not allowed to offset the CA tax, the taxpayer  will pay $194.82 versus $133 with no PTET. 
  Some commentators have suggested that CA residents set up holding companies to hold their interest in a New York pass-throughs; this would give them the flexibility to avoid the PTET which isn't to their advantage.

• Determining the benefits of the PTET as it relates to Partnerships seems fairly straightforward.  The pass-through tax is determined on the aggregated items of income and loss of the partnership including guaranteed payments and capital gains to partners.  New York resident partners are withheld on 100% of  their share of the income and non-resident partners are withheld on their share of New York sourced income.
  However, In determining the benefits of the PTET with respect to S-Corps, one must consider the interplay between maximizing profits subject to the deductible passthrough tax and reducing the QBI deduction to the shareholders if salaries of owner-shareholders are reduced.  

  • Assuming a single shareholder S-Corp, on $1,000 of incremental income taxed at the highest federal and New York marginal rates, if there is already sufficient wages to maximize the QBI deduction, the S-corporation is best off casting the incremental income as ordinary income and not W-2 wages.  The shareholder-employee will get a QBI benefit of $74 and a benefit on the New York PTET of $32.  In total they save $106.

  •  If there is not sufficient wages to maximize the QBI deduction, the S-corporation must choose between casting the payment as W-2 wage salary which will give rise to an incremental QBI deduction of $37 (50% of W-2 wages x 20% QBI deduction x 37% federal top rate x $1,000). The shareholder benefit in that situation would forego the NY PTET benefit of $32 (10.95% top NY rate x (1-37% federal top rate x $1,000).

  • The S-Corp employee-shareholder may be able to obtain a deduction for New York State taxes paid on the wages if the S-Corp enrolls in the Employer Compensation Expense Program (ECET) and pays the tax on the wages of all covered employees. The benefit of the ECET to the shareholder employee must be weighed against the compensation costs to the S-Corp employer of covering its employees other than the shareholder-employee.

  • In addition to the variables above, if the S-Corp is also doing business in New York City, it must factor in the effect of distributing the profits as W-2 wages which could minimize the NYC corporation tax of 8.85% versus treating the profit as ordinary income which would increase the PTET benefit and potentially the QBI benefit.  In the example cited above, assuming the corporation does 100% of its business in New York City, every $1,000 that is treated as salary, saves $88.50 but potentially costs up to $106. 

IN SUMMARY

The New York PTET is a terrific opportunity for business owners to reduce their overall tax burden if they are residing in New York.  It may also be an advantage to those owners who reside in other states.  Each business will need to evaluate the benefits to them by October 15th and determine whether the election is suitable to them.  We will continue to monitor the developing guidance from the state and other thought leaders to assist our clients in arriving at the best and customized solution to their circumstances. Please feel encouraged  to contact your Perelson Weiner partners with any questions. We're here to help you.

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