The Tax Cuts and Jobs Act of 2017 (TCJA) set a limit on the amount of state and local taxes (SALT) that people can deduct from their federal taxes. The SALT cap limits a person's deduction to $10,000 for tax years beginning after December 31, 2017 and before January 1, 2026. Many states have recently enacted SALT cap workarounds to protect taxpayers.
In a recent webinar, Venable partners Michael Bloom and Walter Calvert and associate Chris Moran examined New York's workaround and what taxpayers need to know before the October 15 opt-in deadline. Electing this workaround can alleviate the loss of the SALT deduction suffered by many New York taxpayers, both residents and nonresidents who work there.
Background
Many taxpayers in states with high income taxes and property taxes saw their federal income taxes go up after 2017 because of the SALT cap. The cap disproportionately affected those not subject to the alternative minimum tax (AMT), which denies certain tax breaks (including the SALT deduction) to subjected individuals.
For example, a New York taxpayer with $1,500,000 in taxable income would pay $102,750 in state income tax (6.85%). If this person also pays $40,000 a year in real estate taxes, then they would have been able to deduct $142,750 from their federal taxable income if not for the SALT cap (assuming this person is not subject to AMT). With the SALT cap, this person can deduct only $10,000, so their federal taxable income would be $1,490,000 rather than $1,357,250. With the 37% marginal federal tax rate, that is a federal tax increase of $49,118.
Many state workarounds include enacting a pass-through entity tax (PTET). This is essentially an electable tax designed to save taxpayers money.
How New York's PTET works
New York's PTET allows individuals with income from pass-through entities – such as sole proprietorships, partnerships, limited liability companies, and S corporations – to mitigate the loss of their SALT deduction on the income earned through these entities. Generally, pass-through entities do not pay entity-level taxes; instead, the owners are taxed on their allocated shares of the entity's profits. If the pass-through entity elects to pay the PTET, the individual members receive a credit against their New York state income tax liability and a reduction in their federal taxable income.
Partnerships may need to revise their agreements
Sourcing income is extremely important in figuring out how much is subject to tax and allocating deductions. Resident and nonresident owners can face very different tax consequences, depending on the partnership's operating agreement.
For example, there may be a situation in which a resident owner's share of the tax is $10 and a nonresident owner's share is $5 because of how sourcing rules work. Under a standard partnership agreement, equal partners share tax liabilities equally, so the $15 of total tax would be split into equal parts, and each partner's share would be $7.50. If the entity received $100 in taxable income, the resident should have their taxable income reduced by $10 and is entitled to $90 in net cash, while the nonresident member has only $5 attributed and is entitled to $95 in net cash. Many entities will want to revise their operating agreements if electing into the tax, to make sure that the actual allocation and distributions follow from the results that were intended originally, but with a tax structure that doesn't give equal results to equal partners.
Entities should review their LLC agreement to make sure:
- That the appropriate partners are receiving the deduction. They may need to add language stating that the deduction is to be specially allocated to those members receiving the benefit.
- The PTET payment does not change the deal economics. Otherwise, it could become a priority distribution to the partner on whose behalf it was paid. Consider adding specific language stating that PTET payments are added back to determine net cash flow and treated as actually distributed to such member.
Particularly affected industries
New York's PTET regime has particular relevance for individuals working in two industries – funds and entertainment.
Funds are generally structured as pass-through entities – both the fund itself and the management company engaged by the fund. New York's PTET regime could benefit fund principals regardless of the direction in which they ride Metro North in the morning (e.g., New York residents working at funds in Greenwich, Connecticut or nonresidents working at funds in Manhattan).
Similarly, talent in the entertainment industry often works through pass-through entities (loan-out S corporations) that may be eligible to participate in New York's PTET regime. Many S corporations have traditionally bonused out their net profits at the end of the year without taking S corporation distributions. Should they leave those earnings in the pass-through entity to benefit from the PTET?
Comparing New York's PTET with those of other states
When comparing PTET regimes, there are many things to consider:
- Are they mandatory or elective? If elective, must they be elective for all members?
- States don't allow a deduction for state income tax when determining state taxable income. How is this avoidance of the deduction implemented? An addback at the owner level? A reduction in the amount of the credit for the PTET?
- Ideally a PTET applies only to entity-level taxable income of owners who will benefit from a SALT deduction that they do not otherwise get the benefit of. What owners have their shares of taxable income included as subject to the tax?
- State taxes applicable to business entities generally apply only to taxable income apportioned to the state. But resident individuals are subject to state income tax from all sources. Does the state's PTET apply only to apportioned income? Does the tax apply to all income allocable to residents and only to apportioned income allocable to nonresidents? Does this regime apply to S corporations?
- When considering the benefits of the PTET for an entity with nonresident owners, a vital consideration is whether the owner's resident state will allow a credit for the tax. Does the state's law enacting a PTET have a reciprocity provision under which the state will allow its resident taxpayers a credit for "similar" taxes paid to other states under nonresident status?
Looking ahead
Without any legislative action, the SALT cap is scheduled to expire on December 31, 2025. A small but vocal group of Democrats from high-tax states has pushed for a repeal of the SALT cap and threatened to withhold support for the reconciliation bill if it does not include SALT relief. Recently, a temporary two-year repeal of the SALT cap was proposed, which if successful would cost approximately $95 billion per year.
Remember, the deadline to elect into New York's entity-level tax workaround is October 15, 2021. To learn more, watch the full webinar, explore our Tax practice, or contact our attorneys for help with addressing the unique needs of your business.