More On NYS Pass-Through Tax
As discussed in our posts on August 26, 2021 and June 3, 2021, New York State has created an optional pass-through entity tax which can be used as a workaround for owners of pass-through entities that are affected by the $10,000 federal limitation on the itemized deduction for state and local taxes (often referred to as the SALT cap). The optional tax is effective for tax years beginning on or after January 1, 2021.
The Credit on Personal Income Tax Returns is Refundable: New York State TSB-M-21(1)C, (1)I indicates that each owner of an entity will receive a New York State income tax credit for the entity-level tax that was paid on the owner’s share of the entity’s income, if the entity opts into the optional pass-through entity tax. The credit will be claimed on the new Form IT-653, Pass-Through Entity Tax Credit, on each owner’s New York personal income tax return.
To the extent that this credit exceeds the New York personal income tax liability of the owner, the excess will be refunded to that owner, since the credit on Form IT-653 will be a refundable credit.
Assessing the Cost-Effectiveness of the Optional Pass-Through Tax: Practitioners should assess whether the compliance costs of making the election to opt into this new tax and the cost of preparing the annual return are justified by the tax savings from this optional tax. In addition to making the annual election and filing the annual return, beginning with the 2022 tax year, entities will also be required to make quarterly estimated tax payments for this optional tax.
Practitioners should assist clients in assessing whether the potential federal income tax savings is worth the additional compliance costs that will occur if an entity opts to be subject to this new pass-through entity tax. Electing to be subject to this new tax and complying with the rules for it requires additional time and effort; it appears that either the client must spend time doing this extra work, or the client must retain the practitioner to do the extra work. Determining whether the cost of this extra work is justified requires some analysis.
For example, assume that an owner of a pass-through entity has a $100,000 share of income, and assume that the optional pass-through entity tax on this share of income would be $6,850. (This is computed as $100,000 x 6.85%; higher rates can apply, depending on the income level of the pass-through entity.)
This $6,850 of tax would be paid by the entity to New York State, and it would reduce the income reported to the owner on the federal Schedule K-1, since the tax would be a deductible business expense for federal income tax purposes.
Assume that the owner’s federal income tax rate is 35%. This $6,850 reduction of federal income results in a federal income tax savings of $2,398 (35% x $6,850). The owner also receives a credit on the owner’s New York personal income tax return for the $6,850 paid by the entity, and this refundable credit reduces the owner’s New York income tax liability.
Reminder: If the entity does not elect to opt into the optional pass-through entity tax, any New York personal income tax paid by the owner on the $100,000 share of income from the entity will probably not provide any federal income tax benefit for the owner, due to the $10,000 cap that applies to state and local taxes paid personally by the owner.
In this example, the practitioner and the client would need to compare the $2,398 federal income tax savings to the compliance costs of making the election and complying with its requirements.
Obviously, the higher the share of income from the pass-through entity and the higher the federal income tax rate of the owner, the more likely the tax savings will exceed the compliance costs. Conversely, for entities with lower income and/or owners subject to lower federal income tax rates, the compliance costs may be higher than the potential tax savings.