In mid-April, New York Gov. Andrew Cuomo signed into law a budget bill that included a number of tax provisions, including a new Pass-Through Entity Tax (PTE Tax) retroactive to Jan. 1, 2021. The new PTE Tax could provide significant benefit to certain businesses and owners, particularly those in the financial services industry as described below. For an overall summary of the budget bill, please read our alert, New York to increase income tax rates; enact SALT workaround.
Overview of the new PTE Tax
First and foremost, the PTE Tax is optional. Accordingly, eligible taxpayers must decide whether the potential benefits of electing into this program outweigh the potential increased compliance costs and risks associated with PTE Tax, both for the entity and its partners.
Under the newly enacted Article 24-A (Article 22 is the personal income tax), eligible partnerships and S corporations can make an annual election to participate in the PTE Tax. An ‘eligible partnership’ is defined as a partnership (including limited liability companies taxed as a partnership) with a filing requirement under New York tax law, except for publicly traded partnerships. An eligible S corporation is defined as a New York S corporation subject to New York tax. Generally, the election is required to be made by the due date of the first estimated payment (i.e., March 15th). For 2021 only, however, the election must be made no later than Oct. 15, 2021. The election, once made, is irrevocable by the taxpayer for the given tax year without approval by the state. Article 24-A provides a number of procedural rules regarding who can make the election, and imposes joint and several liability on the partners/members for unpaid pass-through entity taxes. Once the entity makes an election, it applies to all of its partners/shareholders.
An electing partnership or S corporation is required to pay the PTE Tax in four equal installments on March 15, June 15, September 15 and December 15 during the current tax year. For the 2021 tax year, estimated payments are not required by the electing partnerships or S corporations but individuals are still required to make estimated tax payments at their level. It should be noted that the state has not released guidance on the manner by which individuals’ estimated tax payments for 2021 tax year will be applied to the PTE Tax for 2021.
For partnerships, the pass-through entity’s tax base includes (1) the New York sourced income attributable to nonresident members included for personal income tax purposes (Article 22), and (2) all of the pass-through entity’s income attributable to New York resident members for personal income tax purposes (Article 22). For S corporations, only New York-sourced income subject to the personal income tax (Article 22) is included in the pass-through entity’s tax base for the entity’s income attributed to both resident and nonresident shareholders. Income allocated to corporate partners is not included in the tax base.
The pass-through entity electing into this tax regime will pay tax at a rate ranging from 6.85% to 10.90%, corresponding to the new tax bracket schedule for high-earners effective Jan. 1, 2021. Partners or members, including nonresidents, will receive a full credit for their share of taxes paid by the pass-through entity. The entity will be subject to annual certification requirements and will be required to report the partners/members share of income and credits as required by New York state. The partner will receive a refund to the extent they overpaid estimated taxes in 2021 – however, such refunds may have to wait until they file their returns, which could be during October 2022.
The state also amended the credit for taxes paid provisions to expressly allow residents to claim a resident tax credit for taxes paid under “substantially similar” pass-through entity tax workaround programs imposed on partnerships and/or S corporations. As of the writing of this article, about a dozen states have enacted a pass-through entity tax workaround.
Considerations for financial services businesses
One noteworthy provision included in the final version of the tax is that for partnerships (but not S corporations), the pass-through entity tax base is not limited to income sourced to New York state. Accordingly, for partnership entities that are engaged in investment type activities such as hedge funds or general partners earning carried interest, the tax base should include income attributable to resident partners, even if they would otherwise not be considered New York sourced income. Under IRS Notice 2020-75, however, the partnership would still be required to meet the requirements for deducting taxes under sections 164 and 212 (for trade or business expenses).
By electing into the PTE Tax, New York residents can essentially receive a federal tax benefit for their share of taxes paid by the pass-through entity, even if the income would not otherwise be considered New York-sourced income. The following are two examples highlighting this treatment:
Example 1: Historically, in the case of a domestic hedge fund, none of the entity’s income would be considered from New York sources and therefore subject to tax at the partners’ state of residency. Under the PTE Tax regime, the fund (assuming it is an eligible partnership) could elect into the PTE Tax and pay New York tax with respect to income distributable to New York resident partners. Thus, if 50% of the entity is owned by New York residents, 50% of the entity’s income would be subject to the PTE Tax if the election is made timely. Assuming the tax meets the qualification under IRS Notice 2020-75, this tax is intended to have the effect of being deductible for federal income tax purposes. The partners will also receive a full credit for their share of taxes paid by the entity.
Example 2: Similar to Example 1, in the case of a New York-based entity earning carried interest from a private equity or hedge fund, none of the entity’s carried interest income would be considered from New York sources under the general rule and therefore subject to tax at the partners’ state of residency. Under the PTE Tax, the fund (assuming it is an eligible partnership) could elect into the PTE Tax and pay New York tax with respect to income distributable to New York resident partners.
Presumably, the current apportionment rules would apply to determine whether income is sourced to New York for purposes of calculating the tax base for nonresident partners or shareholders. For S corporations, New York generally applies a market-based sourcing approach, using a single-receipts factor. For partnerships, New York has not adopted general market-based sourcing – instead, income is allocated to New York using either the books and records approach, if that approach accurately reflects New York activities, or the three-factor approach consisting of relative property, payroll and gross income in New York. Taxpayers who have established offices outside of New York due to COVID-19 or a shift to a remote workspace may want to reconsider the impact of reducing their New York apportionment, as a higher New York apportionment would increase the tax base eligible for the federal tax benefit.
Financial service companies must also consider whether payments made under the PTE Tax would be considered an expense of the business, or should be allocated to the partners/members receiving the benefit. Such companies should also factor in the consequences of a potential repeal of the federal SALT limitations and the increased compliance burden associated with tracking payments allocated to each partner/member.
Additionally, even with the changes to New York’s resident tax credit, taxpayers should be cognizant of any limitations on the credit when subject to other state pass-through entity workaround provisions, such as New Jersey’s elective tax. The New York resident credit is only available for “substantially similar” programs in other states. While over ten other states have an active workaround, each workaround is legislatively unique and how New York will determine “substantially similar” is not yet known. However, New York resident partners that have been reluctant to elect into New Jersey’s program, or other state workarounds, should still reconsider the viability of such elections if there was initial hesitancy due to the availability of New York’s credit for taxes paid.
New York is one of latest states to provide a pass-through entity tax regime designed as a workaround to the federal $10,000 limitation on state and local tax deductions. For an overview of such programs and the federal guidance sparking an interest in such legislation, please read our alert: Not a panacea: State pass-through SALT deduction workarounds.
With New York now providing a workaround to the SALT deduction limitation, there is significant potential to reduce individual partner and shareholder’s federal tax liability by shifting their state tax liability to partnerships and S corporations. While New York has previously attempted other workaround programs, such as a payroll-type tax, it is anticipated that the PTE Tax will be very popular, in particular for the financial services industry, assuming the federal SALT deduction limitations are not repealed. Please contact a member of the RSM SALT team if you would like to discuss this provision in greater detail. We anticipate New York to issue guidance regarding further procedural matters relating to the PTE Tax.