The annual New York State budget which was signed by the Governor earlier this week contains a new elective pass-through entity tax on partnerships and Subchapter S corporations (the “PTE Tax”). Investment managers organized as partnerships or S corporations will need to carefully consider whether to elect the application of the PTE Tax.
Background
As part of the Tax Cuts and Jobs Act of 2017, the deductibility of state and local taxes by individual taxpayers was limited to $10,000 per year (the “SALT deduction limitation”). In response to this change in law, several states, including New Jersey and Connecticut, have enacted entity level taxes on pass-through entities. However, it was not entirely clear whether such pass-through entity taxes would be deductible for federal income tax purposes.
In November 2020, the IRS issued Notice 2020-75 which held that pass-through entity taxes (whether elective or mandatory) imposed directly on a pass-through entity are not subject to the SALT deduction limitation.
Amount of PTE Tax
The PTE Tax imposes a graduated income tax (at rates from 6.85% to 10.90%1) on the “pass-through entity taxable income” of any partnership or S corporation which elects to be subject to the PTE Tax.
The “pass-through entity taxable income” is the sum of (x) the taxable income of the entity allocable to New York resident individual partners and (y) the New York source taxable income of the entity allocable to non-New York resident individual partners. In other words, only the income that would otherwise be taxable by New York State to individual partners is subject to the PTE Tax. It is not entirely clear whether the PTE Tax liability can be specially allocated among partners.
The amount of PTE Tax imposed on a pass-through entity is creditable by an individual taxpayer against the individual’s New York State personal income tax liability. Any excess credit (i.e., the individual’s share of PTE Tax in excess of the individual’s tax liability on the entity’s income) is refundable to the individual taxpayer.
Election and Estimated Tax Payments
The application of the PTE Tax is elective on an annual basis. A partnership or S corporation must elect to have the PTE Tax apply no later than the first estimated tax payment date (March 15 for calendar year taxpayers). Once made, such election is irrevocable for the taxable year. Special rules, discussed below, apply for 2021.
An entity that elects application of the PTE tax must make estimated tax payments with respect to its tax liability on March 15, June 15, September 15 and December 15 of each taxable year.
Special Rules for 2021
For 2021, no estimated tax payments are due with respect to the PTE Tax. Rather, partners and shareholders of entities electing the application of the PTE Tax should continue to make their regular individual estimated income tax payments in lieu of the entity making estimated payments of its PTE tax liability.
Solely for the 2021 tax year, a partnership or S corporation may make an irrevocable election to apply the PTE tax by October 15, 2021.
Takeaways
The PTE Tax appears to be an effective mechanism for owners of pass-through entities to receive a federal income tax deduction for the payment of New York State taxes that would otherwise be non-deductible under the Tax Cuts and Jobs Act of 2017. However, pass-through entities with non-resident partners or shareholders will want to carefully review whether the PTE Tax is creditable against a non-resident individual’s tax liability in his or her state of residence.
Taxpayers should be aware of the October 15 deadline for electing application of the PTE Tax for 2021. For taxable years starting in 2022, taxpayers may need to modify their existing practices regarding tax distributions and payments of estimated taxes if they elect to be subject to the PTE Tax. For example, rather than having individual partners pay estimated New York State income taxes on their share of income from a pass-through entity, the entity itself would make estimated tax payments for the PTE Tax.
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For additional information on the PTE Tax, please contact Jonathan P. Brose (212-574-1615), James C. Cofer (212-574-1688), Ronald P. Cima (212-574-1471), Daniel C. Murphy (212-574-1210), Brett R. Cotler (212-574-1269) or Tyler Combest (212-574-1472).
