Good News-Bad News: Is the New York Entity Tax Election Worthwhile?By Jennifer Prendamano | July 27, 2021
The State of New York recently enacted an optional pass-through entity tax (PTET) which is effective for tax years beginning on or after January 1, 2021. Many businesses may want to take advantage of this new tax as a workaround to the so-called “SALT Cap” which limits the amount of state and local taxes an individual is permitted to deduct on their federal tax return each year to $10,000. Although there are some advantages to the New York PTET and many taxpayers may benefit from it, they should also be aware of the following disadvantages before deciding whether or not to elect in to this new tax:
Credit for Taxes Paid to Other States – Investors in pass-through entities (PTE) who live outside of New York, New Jersey and Connecticut may find their states of residence will not allow a credit against its tax for the PTE tax paid to New York at the entity level. For example, a Pennsylvania resident may not be permitted to claim credit for the New York PTET paid against their Pennsylvania income tax liability. This will, in essence, partially reduce some of the overall benefit of the New York PTET paid by the entity.
Nonrevocable Election - Once a PTE makes the election to pay the New York PTET, it cannot revoke the election for that tax year. Situations may occur where a PTE may want to elect out of the PTET but is prohibited from doing so. For example, the PTE may become aware that a major individual investor is located in a state that does not allow it to claim a credit for the New York PTET paid. If the PTET election has already been made for the year, it is irrevocable.
PTET Estimated Tax Payments - Since the New York PTET is an entity-level tax, the entity itself must make estimated tax payments. This will result in cash flow implications for PTEs by leaving less cash available to pay out to partners as tax or profits distributions. Some partners may not realize or may simply forget that the PTE is now paying their state taxes for them if they see that their monthly draws are being cut by 6% to 9%.
Distortion of PTET Credit - The New York PTET is an operating expense of the entity. For entities which are taxed as partnerships, the tax deduction will be shared by all partners in accordance with the partnership’s profit and loss sharing formulas/percentages. Since the PTET credit can only be passed-through to individual partners, distortion can result. Also, if the PTE has both New York resident and nonresident individual partners, the entity-level tax would be borne by them in accordance with the profit and loss sharing formula/percentage as well, which can lead to distortion. To avoid this, it may be a good idea to amend the partnership, LLC or LLP operating agreement so the PTET deduction and corresponding credits can be specially allocated among the partners. This will require hiring and paying attorneys to amend the agreement. Additionally, it is possible some investors may want to use the opportunity to make unrelated changes that other investors will not be fond of.
Individual Estimated Tax Payments - For the 2021 tax year only, individual investors of PTEs who elect to pay the New York PTET are still required to make individual estimated tax payments without regard to their share of the New York PTET credit to avoid estimated tax penalties. This results in New York receiving a temporary windfall due to the duplicate payments made by both the individuals and the entity itself. Although New York will refund the overpaid taxes back to the individual investors as long as they file tax returns, overpayments of the New York PTET do not earn interest. Therefore, New York will temporarily get to keep the money as an interest-free loan until individual investors file their personal income tax returns.
Potential Federal Taxation of State Tax Refunds: Generally, a taxpayer who receives a refund of state taxes previously deducted on a prior year's federal income tax return must include the refund in gross income to the extent of any prior federal income tax benefit. Therefore, in the case of an individual who is an investor in a PTE that passed through a PTE credit, their federal AGI would be reduced by the amount of the PTE tax deducted at the entity level. If the partner’s New York return reflects an overpayment, the tax benefit rule may require inclusion of the refund or overpayment in federal AGI in the year in which the refund or overpayment is credited. If the partner also made estimated tax payments and/or had state taxes withheld, it is unclear whether they could attribute the refund to those taxes (for which they presumably did not get a deduction) or whether they would have to employ a pro-rata analysis and attribute some of the refund to non-deducted taxes and the remainder to the PTE credit. New York tax law does not give a preference as far as ordering of refundable credits such as the PTE credit.
Since the New York PTET has benefits and drawbacks, we recommend that each PTE prepare a model of the total tax effect to both the entity and investors that would result from making the irrevocable election. In addition, each entity should review whether nonresident investors would be permitted to take a credit for the New York PTET in their states of residence.
About Jennifer Prendamano
Jennifer Prendamano, JD, is a Director in the Tax Services Group at Marks Paneth LLP. To this role, she brings nearly 20 years’ experience in tax controversy matters at the federal, state and local levels as well as strategic state tax planning and consulting. Ms. Prendamano routinely handles complex state and local tax issues for large, multi-state corporations as well as high-net-worth individuals, and focuses on IRS examinations, state and local income tax examinations at... READ MORE +