Prior to the Tax Cuts and Jobs Act (TCJA), as signed into law in December 2017, amounts paid by taxpayers towards state and local taxes were eligible to be used as a federal itemized deduction to offset federal taxable income. These state and local taxes (SALT) could include state income tax payments, real property taxes, personal property taxes and general sales taxes.

With the passage of the TCJA came the state and local tax deduction limitation of $10,000 in aggregate for the calendar year, effective for taxable years beginning after December 31, 2017 and before January 1, 2026. For many New York state residents, this amount is usually exceeded quite easily based on state income taxes withheld and higher real estate taxes paid. The limitation of SALT deduction has proven to be a point of interest for multiple states to address, and to try to find a work around for taxpayers to maximize the federal tax benefit of these expenses.

In an attempt to help its resident taxpayers, New York State attempted to use the much higher federal itemized deduction limitation of charitable contributions to the taxpayers’ advantage; by setting up a charitable fund that would collect a donation and the donation amount would then qualify to offset real estate taxes due. The Internal Revenue Service (IRS) was prompt in issuing regulations which denied this work around.

On November 9, 2020, the IRS issued Notice 2020-75 to clarify the ability to include state and local taxes imposed on and paid by a pass-through entity (PTE), such as a partnership or S-corporation, as a deduction in computing non-separately stated income or loss. In taking advantage of this notice, New York State has signed into law the Pass-Through Entity Tax (PTET). This will be an annual election to have income taxed and paid at the entity level by an eligible partnership or S-corporation for New York State tax purposes. In addition, any direct individual partner or shareholder of the entity will be eligible for a credit for the tax paid on their behalf included with the entity’s New York State return.

To be considered eligible, a PTE must have a New York tax return filing obligation from income from New York sources, or one or more New York resident partners. If determined to be eligible, a PTE must then make the election annually to pay the tax through quarterly estimates. In general, the PTE must make the election by the due date of the first quarter estimate payment, which is March 15 of the taxable year. For the year 2021 however, there has been an extension of the election date to October 15, 2021. Once the election has been made for a taxable year, it cannot be revoked.

The PTET will be imposed on the New York sourced income of the partnership or S-corporation. The tax rate that applies is based on the taxable income:

Taxable income as referenced above should take into account state modifications, such as decoupling from bonus depreciation. The estimated amount of tax owed by the entity will be due in quarterly installments on March 15, June 15, September 15, and December 15 of the taxable year.

In years that the PTET is elected, individual partners and shareholders of the electing PTE will be able to include the tax credit for New York State as part of the calculation in determining estimated tax payments due for their individual income tax returns. However, for 2021 only, estimates are not required to be paid by the PTE for the 2021 taxable year. Instead, partners and shareholders will still be required to make estimated tax payments as if the credit will not offset their state tax liability.

Guidance is still needed in determining how state taxes paid by individual partners and shareholders of an electing PTE will be captured as part of non-separately stated income at the entity level, since the entity itself is not paying the tax. The likely outcome is that New York State will allow estimated payments from the individual partners and shareholders as well as the eligible PTE, and the overpayment then is eligible for refund when individual tax returns are filed.

To better explain how the PTET tax affects a partner or shareholder of a PTE, let’s work through a simple example. Say we have a partnership of four equal partners, with all New York sourced income of $1,000,000 and the partnership elected for the Pass-Through Entity Tax. The partnership or S-corporation would be required to make estimated payments in total of $68,500 ($1,000,000 x 6.85%). As allowed by Notice 2020-75, this imposed and paid tax would be an allowable portion of non-separately stated income to be allocated to partners or shareholders. This means, for federal income tax purposes, the allocated income amount per partner would be $232,875 (($1,000,000-68,500)/4), whereas without the election the amount allocated would have been $250,000.

The amount of taxes paid by election of the PTET is not required to be reported as a federal itemized deduction since it was paid for at the entity level. This is advantageous for taxpayers as it allows other SALT, such as state income tax withheld and/or real estate taxes to be maximized to the $10,000 limit, while excluding state income tax imposed on pass-through earnings. Another federal tax benefit that comes with the PTET election, is a reduction in self-employment taxes due if the PTE is subject to such taxes.

For purposes of New York State income taxes, the amount of PTET paid will be an addition to the Federal AGI amount, showing the full amount of income from the PTE as taxable in New York. The amount of tax paid by the entity is then deducted from the partner or shareholder’s total tax liability as a credit for their portion of the taxes paid by the entity on their behalf. It will be an important to consider if making the election, tax rate that applies to the entity could potentially be higher than the New York State income tax rate without the election.

For New York State residents, the benefits of making the pass-through entity tax election can be quite clear. However, complications arise with nonresident partners and shareholders, and income sourced outside of New York. There are also questions around how the electing entity will collect the money for the estimated payments, will the amounts paid affect partner draws or compensation, and what kind of agreements should be documented on how the election will affect partners and shareholders administratively.

While guidance is still needed on multiple topics for the pass-through entity tax, there are certainly benefits to this legal work around of the state and local tax deduction limitation. If you have any questions about how the election of the pass-through entity tax affects you or your business, please do not hesitate to contact your tax advisor at Dermody, Burke & Brown.

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.