Guidance Recently Issued on New York State’s New Elective Pass-Through Entity Tax
Client Alerts | September 1, 2021 | Hedge Funds | Private Equity Funds
Tax Planning for Fund Managers and Other High-Net-Worth Individuals
Earlier this year, New York State enacted a new elective pass-through entity tax (the “PTET”). The PTET generally allows individuals who are members of pass-through entities to effectively receive a federal deduction for New York State income taxes that they would otherwise not be able to deduct. On August 25, 2021, the New York State Department of Taxation and Finance released TSB-M-21(1)C (the “Technical Memorandum”), which provides guidance on the PTET.
This newsletter describes the basic mechanics of the PTET, discusses potential significant planning opportunities for New York State residents and non-New York State residents with New York source income, and highlights certain aspects of the Technical Memorandum.
As discussed below, an election to pay the PTET for 2021 must be made online on or before October 15, 2021.
The 2017 Tax Cuts and Jobs Act (the “TCJA”) imposed a $10,000 annual cap on the deduction of certain state and local taxes, including income taxes and real property taxes, for the years 2018 through 2025 (the “SALT Cap”).
As a result of the SALT Cap, many states including Connecticut, New Jersey and New York, have enacted pass-through entity taxes to help their residents (and potentially non-residents) effectively deduct state and local taxes which would otherwise have been subject to the SALT Cap.
In response to the enactment of such taxes, the Department of the Treasury and the Internal Revenue Service (the “IRS”) issued Notice 2020-75 (the “Notice”) which clarified that an owner’s share of state and local income taxes (whether mandatory or elective) imposed on a partnership or S corporation at the entity level is not subject to the SALT Cap. There is some uncertainty as to whether the Notice applies to owners of pass-through entities that are not engaged in a trade or business (e.g., investor funds) since the Notice may be viewed as recharacterizing such taxes as nondeductible miscellaneous itemized deductions.
Basics of the PTET
The PTET applies to partnerships (including limited liability companies that are treated as partnerships for tax purposes) and S corporations. The PTET is imposed at a rate that ranges from 6.85% to 10.9%, depending on the amount of income of the pass-through entity. Because the PTET does not apply to sole proprietorships, a sole proprietorship may not elect into the PTET unless it is restructured as a partnership.
The PTET base for a partnership is the sum of (i) its New York source income allocated to non-residents of New York State, and (ii) all of its income allocated to New York State residents. Thus, partnerships allow New York residents to receive the benefit of the PTET on income that is not sourced to New York, such as income from investments, including a carried interest. The PTET base for an S corporation is its New York source income.
The PTET is creditable at the individual level against New York personal income tax. Any excess credit is refundable. The PTET and offsetting credits only apply to direct individual owners of the pass-through entity; owners of pass-through entities that are not individuals, such as corporations or partnerships, are not entitled to any credit with respect to their share of the PTET of the lower tier partnership and, consistently, their share of the lower tier’s income is not subject to PTET at the lower tier level. Rather, such entities can elect to apply the PTET at their level.
For New York resident owners, the PTET is designed to be tax neutral from a New York tax perspective. For non-New York resident owners of an entity that elects to pay the PTET, the issue generally depends on whether their home state allows a credit for the PTET. Many states that have enacted a pass-through entity tax (including New York) allow their residents to claim a credit for a substantially similar tax paid to another state. Although no official guidance has been published, both Connecticut and New Jersey have unofficially stated that the New York PTET would be considered a substantially similar tax for this purpose, and thus a Connecticut or New Jersey resident would be able to claim a credit against their Connecticut or New Jersey tax for their share of the New York PTET.
Because the PTET is deductible as a business expense, it appears that such tax is not added back in determining the alternative minimum tax, and thus a taxpayer could in fact be better off under the PTET than under rules in effect prior to the TCJA.
The PTET offers significant tax planning opportunities to New York State residents with substantial income and non-New York State residents with substantial New York source income.
Assuming approximately a 10% New York State tax rate and a 40% federal income tax rate, the potential tax benefit of the PTET is roughly 4% on an after-tax basis.
Similarly, as a business expense, the PTET could potentially reduce self-employment income and, thus, self-employment tax.
Although an election for 2021 is not required to be made until October 15, 2021, planning and possible structuring or restructuring should be considered now to maximize the potential tax benefits. For example, a sole proprietor could consider contributing his or her assets to a new partnership so that the partnership could elect to pay the PTET for income earned after becoming a partnership.
Fund managers should evaluate the potential benefits to owners of the management companies and carry vehicles and consider whether it makes sense for the management companies and carry vehicles, or their owners, to engage in any planning for the PTET.
For example, principals that invest directly in a fund may want to contribute their fund interests to a partnership and have the partnership make the PTET election. As another example, it may be possible to have some highly compensated employees receive some of their compensation as partnership income since the PTET does not offer benefits with respect to taxes paid on employee compensation.
Operating agreements may need to be amended to address the PTET and how the PTET is allocated among the owners of a pass-through entity. Note, while S corporations can elect to pay the PTET, they do not have the ability to specially allocate the PTET to specific members as can be done in a partnership.
Recent Guidance – the Technical Memorandum
The following are certain noteworthy aspects of the Technical Memorandum:
- Only certain authorized persons may make the election on behalf of a partnership or S corporation and the election must be made online.
- The PTET return for an electing entity must be filed online and, once filed, may not be amended for any reason.
- The PTET return must report total PTET and the direct share of the PTET being allocated to each owner of the entity. If the pass-through entity does not provide sufficient information on its return to identify all credit-eligible owners and their credit amounts, the owners will not be entitled to a credit for the PTET on their personal income tax returns.
- The Technical Memorandum provides specific guidance on how to calculate pass-through entity taxable income for partnerships and S corporations. A partnership must compute its “resident PTE taxable income pool” and its “nonresident PTE taxable income pool” and if a partnership has members who have a special allocation, the partnership must take these allocations into account when computing each pool. A partnership must also compute each owner’s profits and loss ownership percentage within each pool. The taxable income pools and the profit and loss percentages are used to determine the credits that are available to resident and non-resident owners of the pass-through entity.
- For an S corporation, each owner’s percentage is simply their ownership percentage multiplied by the total PTET paid by the S corporation.
- Owners of pass-through entities that elect to pay the PTET must still make personal income tax estimated payments for 2021 as if they were not entitled to the credit for the PTET. This results in double taxation of the owners of the pass-through entity until such time as a refund is received. For years beginning after 2021, personal estimated tax payments can take into account the PTET paid at the entity level.
- Special rules apply to partnership and S corporations that do not use the calendar year as their taxable year.
- Specific guidance is provided on how the owners of an entity that has elected to pay the PTET may claim a credit for the PTET.
A pass-through entity may elect to pay the PTET with respect to taxable years beginning on or after January 1, 2021, and before January 1, 2024. An election is made on an annual basis, so a pass-through entity can make the election for one year but is not required to make the election for another year. The election for 2021 must be made online on or before October 15, 2021. For 2022 and 2023, the election must be made online on or before March 15th of such year.
Estimated tax payments for the PTET are not required for 2021. However, to receive the tax benefit of deducting such taxes in 2021, for cash basis taxpayers, the PTET must be paid by December 31, 2021.
There are current proposals to change the SALT Cap. A total repeal of the SALT would mostly obviate the need for the PTET. An increase in the SALT Cap would decrease the tax benefits of the PTET.
The PTET offers significant tax planning opportunities. If you have any questions regarding the PTET and planning opportunities as they apply to you, please contact one of the members of our Tax Department.