NYS Optional Pass-Through Entity Tax
The New York State 2021 to 2022 budget creates an optional pass-through entity tax which can be used as a possible workaround for owners of passthrough 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.
While guidance on electing and implementing this new tax is not yet available, this new workaround has the potential to provide tax-savings for many taxpayers who own pass-through entities. As a result, practitioners should begin identifying affected clients and discussing the election with such clients.
Under the new rules, a pass-through entity (i.e., an S corporation, partnership or LLC taxed as a partnership) can elect to be subject to an entity-level tax on the pass-through income that it reports to its owners. The tax rate is 6.85%, if the entity’s income is not over $2 million. For income over $2 million and up to $5 million, the tax rate is 9.65%. For income over $5 million and up to $25 million, the tax rate is 10.3%. For income over $25 million, the tax rate is 10.9%.
The concept of this SALT workaround is that the entity will pay a tax that can be deducted when computing its income for federal tax purposes. Therefore, this state tax will reduce the income reported to each owner on Schedule K-1. Thus, the owners will get the benefit of a federal deduction of the state tax that is imposed at the entity-level through the reduction of income that would otherwise be reported on Schedule K-1, and the entity-level tax escapes the $10,000 cap that otherwise applies to state and local taxes that are paid personally by owners.
On the New York personal income tax return for the owners of the entity, the entity-level tax must be added back to New York adjusted gross income, similar to way the New York State franchise tax on S corporations is currently added back to New York adjusted gross income.
However, each owner of the 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. As a result of this credit, the New York State personal income tax that would be due on the owner’s share of the entity’s income is offset by the entity-level tax paid by the entity to New York. Effectively, this shifts the payment of the tax from a personal tax payment (which is limited by the SALT cap) to an entity-level tax payment (which is not limited by the SALT cap).
Each year, entities must elect whether they will be subject to the pass-through entity tax. Normally, this election must be made by March 15 of each tax year to be effective for that tax year. For the 2021 tax year only, as a transition, it is expected that the election will be permitted to be made as of a later date, perhaps October 15, 2021, but New York State has not yet provided guidance on the due date for the election for the 2021 tax year.
Entities that elect to pay the pass-through entity tax will be required to file a new, annual tax return by March 15 that covers the prior calendar year.
Normally, the pass-through entity must pay quarterly estimated taxes equal to 90% of the pass-through entity tax for the current year or 100% of the pass-through entity tax for the prior tax year. Such estimated tax payments are due on March 15, June 15, September 15 and December 15. New York State has not yet issued guidance about the transition and the due dates for the 2021 tax year.
New York State is expected to issue details and guidance about this new tax in the near future.