Can New York State’s Pass-Through Entity Tax Program Help Reduce your Overall Tax Burden?

For tax years beginning on or after January 1, 2021, eligible pass-through entities may elect to pay a New York Pass-Through Entity Tax (PTE). The optional PTE is a state income tax that is imposed on the pass-through entity (i.e., an entity that is classified as a partnership or S corporation for federal and New York State income tax purposes). The direct partners, members or shareholders of an electing pass-through entity receive a refundable credit against their New York personal income tax based on their respective share of the PTE.

Why is the PTE a big deal?

The federal Tax Cuts and Jobs Act (TCJA) of 2017 placed a $10,000 cap on the federal personal income tax state and local tax itemized deduction effective starting tax year 2018 – the notorious SALT Cap. The PTE is designed to eliminate the adverse impact that the SALT Cap has on a pass-through owner’s federal income tax liability. The SALT Cap limits the federal personal income tax itemized deduction for New York State and New York City personal income taxes and New York real property taxes. The $10,000 limitation is particularly costly to New York resident and nonresident taxpayers since, as of 2021, New York has the highest combined state and local tax rate in the country (the highest earning residents of New York City will pay a top combined rate of 14.776%).

Notably, the PTE election and the potential corresponding tax benefit are not applicable to sole-proprietors or disregarded single member limited liability companies (SMLLCs). To qualify for the PTE election, sole-proprietors and disregarded single member LLCs should consider adding a partner or member (to be classified as a partnership for tax purposes) or incorporate and make an S corporation election. Alternatively, disregarded SMLLCs could “check the box” to be taxed as a corporation and then make an S corporation election, which can be retroactive for up to 75 days. To obtain the benefits of the PTE for the remainder of the 2021 tax year, affected taxpayers should undertake these actions promptly.

Some Nuts and Bolts

The PTE rates mirror the New York State personal income tax rates (ranging from 6.85% to 10.90% depending on the amount of pass-through entity taxable income). An electing partnership’s pass-through entity taxable income includes its individual resident and nonresident partners’ shares of income, gain, loss or deduction included in their New York taxable income (note that for nonresident partners this amount includes only New York source items).

In the case of an electing S corporation, pass-through entity taxable income includes only the income derived from or connected with New York sources.

Making the Election

The PTE election is made annually by the due date of the first estimated payment (i.e., March 15) and is irrevocable for the year elected. For 2021 only, the election is due by October 15, 2021 and partners must continue to make estimated income tax payments (the partnership does not make estimated PTE payments for 2021). It is expected that through future guidance the State will provide a mechanism by which individuals’ estimated income tax payments for 2021 will be applied to the PTE for 2021.

How the PTE Mitigates the Impact of the SALT Cap

The PTE effectively converts individual State income tax (which is limited by the SALT Cap) into a business tax paid by the entity. For federal purposes, when the entity computes its non-separately stated income, it deducts the PTE as business expense (instead of the partner, member or shareholder deducting state and local income taxes as an itemized deduction on their federal personal income tax return, thereby bypassing the SALT cap). The PTE is added back when computing a pass-through owner’s State taxable income. Note, the PTE credit applies only to State income tax. The PTE credit does not apply to local income taxes (e.g. the New York City resident income tax) nor to real property taxes.

Partners, Members, and Shareholders PTE Personal Income Tax Credit

If the PTE election is made, individual owners of the pass-through entity (including trusts subject to the New York State personal income tax) will receive a corresponding New York State refundable personal income tax credit equal to each owner’s share of the PTE. Notably, the legislation also allows residents of New York to take a credit against their personal income tax for pass-through entity tax paid to other states, provided that the other state’s pass-through entity tax is substantially similar to the New York PTE.

By the Numbers – A Simple Example of the PTE Benefit to Members

Example assumes all NY resident partners:

Real estate management company with two 50% NY resident partners earns $1 million, all from NY sources
Assuming NY tax rate for both the PTE tax and the personal income tax (PIT) of 10%

If no election is made:

Each partner receives $500,000 earnings
Each partner pays $50,000 NY PIT

For federal income tax purposes, each partner is limited to a $10,000 deduction for state and local taxes (SALT), most likely already taken in the form of a property tax deduction.

Assuming a 40% federal tax rate1, the tax liability of each partner would be:

$500,000 x 40% =$200,000$500,000 x 10% =$50,000Total tax per partner$250,000

Total tax for all partners$500,000

If the PTE election is made:

Each partner receives $450,000 earnings ($1 million less $100,000 of tax/ 2)

For federal income tax purposes, the SALT limitation is no longer a concern as the $50,000 of NY PTE tax reduced the pass-through entity income.

Assuming a 40% federal tax rate, the tax liability of each partner would be:

$450,000 x 40% =$180,000Reduced earnings from PTE tax$50,000NY PIT ($500K x 10% - $50 PTE tax credit)$0Total tax per partner$230,000Total tax for all partners$460,000

Potential Savings: $40,000.

As the example illustrates, the PTE liability of the partners is now borne by the partnership and accordingly adjustments to partner distributions will need to reflect this.

Additional Considerations

Although electing into the PTE regime can result in substantial tax saving to the owners, it is important to consider that it temporarily decreases an owners’ cash flow. This is because many pass-through entities will make estimated tax payments computed at the highest (10.9%) PTE rate while the entity’s owners may incur New York personal income tax at lower individual tax rates. The excess PTE paid by the entity is recouped when the owners file their returns to claim their refundable credit.

It is certain that the State will issue further guidance on the implementation of the PTE, as important open questions include how it will be implemented for the 2021 tax year and how it will work with tiered structures. Moreover, it is likely that the federal taxing authorities will generally accept the deductibility of the New York PTE, but there may be some push back on its broad scope, since the PTE appears to apply not just to business income.