Federal Tax Savings Opportunities for Business Owners With the NYS Passthrough Entity Tax

On April 7, 2021, the New York State Senate and Assembly passed significant tax legislation as part of the 2021 – 2022 New York State budget (Senate bill S2509-C / Assembly bill A3009-C) which was signed into law by Governor Cuomo on April 19, 2021.

One of the provisions, the Passthrough Entity Tax or “PTET” offers opportunities for owners of partnerships, S-corporations and certain LLCs to reduce their federal tax liability if they make an election to opt into the program by October 15, 2021.

The New York PTE tax, if elected by the entity, creates a tax deduction at the entity level, where it is not subject to the individual SALT limitation, and provides a tax credit to the direct partners, shareholders, or members of the electing entity.

The first question business owners may ask is – why would I want to elect to pay more tax?

Background

The NY Passthrough entity tax was created as a workaround to the federal state and local tax (“SALT”) cap imposed in the Tax Cuts & Jobs Act (“TCJA”). Under the TCJA, individual taxpayers are limited to $10,000 of itemized deductions annually for state and local taxes such as income taxes and real estate taxes. As a result of this cap, a significant portion of many taxpayers’ state income taxes are not deductible. There is no limitation on such taxes paid by a business, however. This disparity in the rules created an opportunity for passthrough entities to shift the tax burden from the owners to the business.

In response to this limitation, many states have elected passthrough entity taxes which create a deductible tax imposed on a passthrough business which is offset by a refundable credit or state tax deduction on the owner’s state tax return.

Initially, many tax experts were concerned that the IRS would not allow a deduction for an optional tax at the business level. When the IRS did finally publish its position on these types of arrangements, in Notice 2020-75, the IRS surprisingly held that it would allow a deduction for such taxes. This favorable opinion led to widespread adoption of similar taxes. Currently at least 20 states, including New York, have adopted a passthrough entity tax.

How is the Tax Calculated?

The Passthrough Entity tax is based on the NYS individual tax rates with different brackets depending on the entity’s New York State taxable income. The rates are as follows:

How is the Taxable Income Calculated for the PTET?

The PTE tax is based on the New York taxable income, including any state modifications such as additions or subtractions for bonus depreciation and modifications for New York state decoupling from the Internal Revenue Code. The initial income, before apportionment adjustments, would be calculated as follows:

Federal Income from the entity (from Schedule K)
Plus: New York State additions
Less: New York State subtractions
Equals New York State Taxable Income

The income is then allocated between resident shareholders and nonresidents. After this point, the calculation is different depending on whether the entity is a partnership or an S-Corporation.

S-Corporations (including LLCs taxed as S-corporations in NY)

The NYS taxable income calculated above is multiplied by the S-Corporation’s New York State business apportionment factor. This factor, calculated by dividing the corporation’s receipts allocated to New York by the corporation’s total receipts can be found on in Part 3 of the corporation’s Form CT-3-S tax return. Because S-corporations may only include their New York source taxable income, corporations with a low percentage of sales to New York customers will receive less benefit from this program than if the business was structured as a partnership.

Partnerships (including LLCs taxed as partnerships)

For partnerships there is a different calculation depending on whether the partners are New York residents. First, the taxable income allocated to partners that are not individuals or trusts is subtracted. (Partners that are disregarded, such as single member LLCs or grantor trusts, this determination will be based on the owner or beneficiary of the SMLLC or grantor trust.) The remaining taxable income is split into two pools: taxable income allocated to resident partners and taxable income allocated to nonresident partners. (The partnership will need to determine the residency of its partners in advance.)

The PTET taxable income will include all of the taxable income allocated to the resident partner’s income pool. For nonresidents, however, it will only include the portion of the income that is considered New York source income. Partnerships generally determine the share of income that is sourced to New York using a 3-factor formula based on the ratio of sales, payroll, and property in New York vs. total sales, payroll and property.

How Will the Entity Pay the Tax?

Annual PTET return

A Passthrough Entity tax return will be required to be filed by March 15 of the following year. For example, entities that opt in for the 2020 tax year will file their return by March 15, 2022. Any balance due (or refund of overpayments) after any estimated PTET payments made by the entity will be due with the PTET return. Businesses may also request a six-month extension of the PTET return. (An extension payment of any balance due will still be required by March 15 to avoid penalties.) New York has indicated the annual PTET return will be filed using an “online return application” so it appears this return will be required to be filed electronically.

Estimated Taxes

Entities subject to the PTET will also be required to make quarterly estimated tax payments which will be due March 15, June 15, September 15 and December 15. For 2021, entities will not be required to make estimated payments however the NYS website will accept 2021 estimated tax payments beginning December 15. Cash basis entities will need to make their PTET payments by December 31 in order to deduct them on their 2021 federal income tax returns.

Each quarterly payment should be 25% of the expected annual payment for the year. Beginning in 2022, interest & penalties pay apply if the  estimated payments are not at least equal to the lesser of 90% of the annual PTET tax calculated for the year on the PTET return or 100% of the prior year’s PTET.

Because the entity is not required to make estimated payments for 2021, New York is requiring individuals to continue to make their own estimated payments without taking into account any anticipated PTET credit.

Fiscal year entities with a year-end other than December 31, will still make estimated payments based on the calendar quarters above.

Claiming the PTET Credit on Owners’ New York Tax Return

Partners and shareholders will receive a refundable credit on their New York state income tax return in the amount of the NYS PTET paid by the entity and allocable to their share of the income. The credit will be based on the actual tax calculated on the PTET return, not on the payments made during the tax year. Thus, if the estimated payments made by the entity exceed the actual PTET, the owners would only receive credit for the actual PTE tax due and any excess PTET payments made by the entity will be refunded to the partnership or S-corporation. The PTET credit will be claimed on Form IT-653, Passthrough Entity Tax Credit.

If partners or shareholders are disregarded entities such as single member LLCs owned by an individual or grantor trusts, the PTET credit will be claimed by the individual owner or beneficiary.

If an individual receives PTET credits in excess of their tax liability, any excess will be refundable or may be applied to the next year’s taxes. State refunds caused by the PTET credit, as opposed to refund of estimates and withholding, may be taxable at the federal level in the year the refund is received.

An addition to New York state taxable income will be required in the amount of the PTET credit received, typically resulting in essentially no tax impact on the owners’ New York tax liability.

Examples

Partnership Example

Assume we have a partnership with two 50/50 partners, Alex and Betty who are both New York residents. The partnership has $900,000 federal taxable income. Because bonus depreciation was claimed this year, a New York state addition modification of $100,000 has been calculated resulting in $1,000,000 total New York taxable income. Based on the apportionment calculated by the partnership, 40% of the partnership’s income is sourced to New York. Alex and Betty are in the 32% marginal tax bracket for federal taxes.

Taxable Income subject to the PTET is $1,000,000. All of the income is allocated to the New York residents pool, so there is no reduction for the income sourced outside of New York. Since the NYS taxable income is less than $2 million, the PTE tax rate will be 6.85% resulting in total PTET of $68,500, reducing the partnership’s federal taxable income by this amount. For 2021, the partnership will be required to make this payment by March 15. Cash basis taxpayers will need to pay early, by December 31, to take the deduction.

Alex and Betty will each receive a PTET credit on their NYS tax returns of $34,250.

We would expect Alex and Betty to save $10,960 each in federal taxes ($34,250 x 32%) but the reduction in adjusted gross income (AGI) typically results in additional savings. If the partnership income is subject to Self-employment (SE) taxes this is often creates additional savings. The tax savings are often offset by a reduction in the 20 percent Qualified Business Income deduction.

Assuming the partnership income is subject to self-employment tax and fully eligible for the qualified business income deduction, Alex and Betty’s savings would be approximately:

Both partners in this example save on their federal income taxes so it will be worthwhile to opt into this system to save almost $20,000 in federal taxes overall.

For partnerships with only New York individual partners, the election should be beneficial if there is sufficient income at the partnership level to make the tax savings worth the administrative burden and if the partners expect to have a tax liability on the federal return.

Situations involving non-residents should be modeled to determine the relative benefits the resident and non-residents will receive. The PTET credits allocated to non-residents will be reduced resulting in credits that may not be in line with the partners’ relative ownership percentages creating disparate economic benefit. Also, unless the partnership elects to amend its partnership agreement to specially allocate the PTET deductions at the partnership level, the federal deduction will be allocated to the partners differently than the refundable credit and resulting add back to New York state taxable income.

S-Corporation Example

Assume the same facts as above except that Alex and Betty formed an S-corporation instead of a partnership. Due to the 40% New York apportionment factor, both shareholder’s taxable income for the PTET will be calculated based on New York source income so the total taxable income would be $400,000 and the PTET would be $27,400.

The savings would now drop to approximately $3,500 of regular tax savings each or $7,000 total. The New York state apportionment of 40 percent caused a significant reduction in the total benefit although it will still be advisable to make the election to save over $7,000 in federal tax.

For both partnerships and S-corporations, nonresident owners will also need to determine whether their resident state will allow a resident credit for the PTET credit allocated to them.

How Can an Entity Opt in to this Program?

Eligible Entities

Only entities that are taxed as partnerships or S-corporations for New York state purposes are eligible. This includes LLCs that are taxed as federal partnerships and LLCs that have elected to be taxed as an S-Corporation for New York state.

Sole proprietorships, rentals, and farms taxed at the individual level (Form 1040 Schedule C, Schedule E page 1, or Schedule F) and single member LLCs that are disregarded and taxed on the 1040 Forms above are not eligible nor are Regular “C” corporations including LLCs or S-corporations taxed for New York as C corporations.

Instructions to Opt-In

Generally, a New York passthrough entity will be required to elect to be subject to this tax by making an election by March 15 of the year in which the tax will apply. The election will be made annually so taxpayers can opt-in one year then and decide not to opt-in the next year.

For 2021 only, the election may be made until October 15, 2021.

To make the election, the entity will need to have, or create, a Business Online Services account. The link to the online services webpage is https://www.tax.ny.gov/online/.

The directions to opt in to the PTET from the Online Services account is as follows:

  • Log in to (or create) the eligible entity’s Business Online Services account.
  • Select the ≡ Services menu in the upper-left corner of the Account Summary homepage.
  • Select Corporation tax or Partnership tax, then choose PTET web file from the expanded menu.
  • On the Form Selection page, choose Pass-Through Entity Tax (PTET) Annual Election.

New York requires that an authorized representative of the business make the election. Tax professionals may not make the election on behalf of their clients.

Bottom Line

The New York state Passthrough Entity Tax program offers opportunities for many owners of passthrough entities in New York to reduce their federal income tax. The deadline is approaching so we recommend taxpayers reach out their tax advisors to find out if this program will benefit them.

Helpful Documents:

 

Please contact us with questions regarding how this new law will impact your taxes.