The tax landscape for businesses is ever-evolving, and in response to changes in federal tax laws, states often implement their own measures to maintain fiscal balance. One such initiative is the New York Pass-Through Entity Tax (PTET), which aims to address the limitations imposed by the federal $10,000 cap on state and local tax (SALT) deductions for individual taxpayers while also alleviating the burden of self-employment taxes for certain partners in partnerships. In this comprehensive guide, we delve into the intricacies of PTET, exploring its origins, key features, and considerations for both pass-through entities (PTEs) and their owners.
Background: What is a Pass-Through Entity (PTE)?
Before delving into the specifics of PTET, it’s crucial to understand the concept of a pass-through entity. PTEs are business structures that do not pay income tax at the entity level. Instead, the income and deductions of these entities pass through to their owners or members, who report this information on their individual income tax returns. Common examples of PTEs include partnerships, limited liability companies (LLCs) treated as partnerships for federal income tax purposes, and S corporations.
Origins of the New York Pass-Through Entity Tax:
On April 20, 2021, former New York State governor Andrew Cuomo signed the New York State 2022 Fiscal Year Budget, which included the elective PTET under Article 24-A, responding to the changing federal tax landscape. The tax became effective for tax years beginning on or after January 1, 2021, signaling a new era for tax planning for eligible entities.
Key Features of NY PTET:
1. Entity-Level Taxation
At the heart of PTET is the concept of entity-level taxation. Eligible pass-through entities can elect to pay tax at the entity level on their New York source income, altering the traditional flow-through taxation model. In essence, the entity is withholding and remitting New York State income tax on the partner/shareholder’s behalf. This method of taxation has the benefit of allowing the entity to deduct the tax expense on its tax return rather than taking the deduction on Schedule A of the partner/shareholders’ personal return. This has tangible tax benefits that will be detailed later in this article.
2. Eligible Entities and Taxpayers
Entities eligible for PTET include partnerships, LLCs treated as partnerships for federal income tax purposes, and S corporations.
In order for a taxpayer to be eligible to receive the benefit of the PTET credit, they must be an individual, trust or single member LLC shareholder who is required to file an income tax return under New York Consolidated Laws, Tax Law § 22 (2023). C corporations, S corporations, partnerships and multi-member LLCs are not eligible to take advantage of the PTET credit.
3. Tax Rate
The PTET tax rate is determined by an income based marginal tax bracket that only considers New York state sourced income. The brackets range from a 6.85% to 10.9% tax on New York income. Understanding the nuances of these rates is crucial for effective tax planning.
How to Elect PTET:
The election to pay tax at the entity level is not a one-time decision. It must be made annually and is due by March 15th of the current tax year. This is done by navigating to the New York State Department of Taxation and Finance website. Logging into the entity’s Business Online Services account and filling out the Pass-through entity tax (PTET) annual election. It is advisable to consult with a tax professional before making this election.
Filling the PTET Annual Return:
Like the election, the PTET annual return must be filed by March 15th. While the election is made for the current tax year, the annual return reports the prior year’s information, meaning that the annual return for 2022 would be filled by March 15, 2023. This follows a similar process as the election. Going to the New York State Department of Taxation and Finance website. Logging into the entity’s Business Online Services account and filing out the Pass-through entity tax (PTET) annual return. The return should identify all eligible partners/shareholders, specifying their taxpayer type (individual, estate, or trust), percentage of ownership, and most importantly, their share of the PTET credit. The annual return can be extended by 6 months, allowing for a September 15th due date if needed. It is generally recommended to file this at or near the same time as the filing date for the federal and New York returns. And once again, it is advisable to consult with a tax professional before filing.
Benefits of the New York Pass-Through Entity Tax:
State and Local Tax (SALT) Deduction Limitation
1. As highlighted in the article’s introduction, the enactment of the PTET credit was prompted by the need to address the deduction limit of $10,000 for state and local tax on Schedule A of Form 1040. Introduced through the 2017 Tax Cuts and Jobs Act, this measure resulted in the loss of substantial deductions for many taxpayers on their returns. The impact was particularly pronounced for homeowners, who could traditionally deduct both property taxes and state income taxes. These taxpayers were limited by the $10,000 cap mentioned above.
With the introduction of the PTET credit, taxpayers who owned pass-through entities could shift the deduction away from Schedule A, where it was capped, to directly lower the amount of income passing through to them. In this case, a home owner could deduct property taxes subject to the $10,000 cap and their New York income tax.
2. Mitigating Self-Employment Taxes
Self-employment taxes, are imposed on individuals working independently. Designed to support social insurance programs, self-employment tax is equal to the combined employee and employer Social Security and Medicare rates. Active partners in partnerships are subject to self-employment tax, while S-Corporation shareholders and passive partners in partnerships are not.
The deduction offered by the New York Pass-Through Entity Tax (PTET) becomes a valuable tool in alleviating the burden of self-employment taxes. By reducing their flow-through self-employment income, certain partners in partnerships can effectively lower the amount owed in self-employment taxes. This strategic use of PTET not only addresses a key challenge faced by business owners but also underscores its role in optimizing the overall tax position for stakeholders in pass-through entities.
Potential Pitfalls of the New York Pass-Through Entity Tax:
While the New York Pass-Through Entity Tax (PTET) offers valuable benefits, there are potential pitfalls that businesses and taxpayers should be mindful of in order to navigate the tax landscape effectively.
1. Complexity of Eligibility Requirements:
The eligibility criteria for both pass-through entities (PTEs) and taxpayers seeking PTET benefits can be intricate. Taxpayers should be mindful of any change in their entity type, as it may result in the loss of PTET advantages.
2. Annual Decision-Making:
As mentioned above the decision to elect PTET is not a one-time commitment. Entities must make this decision annually, which is due by March 15th of the current tax year. This requires a consistent evaluation of the entity’s financial situation and tax implications, adding an ongoing layer of complexity to tax planning.
3. Marginal Tax Rates:
The PTET tax rate is variable and depends on New York source income, ranging from 6.85% to 10.9%. Staying informed about these rates and any potential changes to them is essential for accurate tax planning.
4. Documentation and Reporting Challenges:
Meticulous documentation is required when filing the PTET annual return, including identifying eligible partners/shareholders, specifying taxpayer types, ownership percentages, and PTET credit shares. Inaccurate or incomplete reporting may result in audits, delays in processing, as well as interest and penalties.
5. Changes in Federal Legislation:
The landscape of federal tax laws may evolve, impacting the effectiveness and relevance of PTET. Currently, the SALT deduction cap is scheduled to be sunset following the 2025 tax year, but could be extended with further legislation. Businesses and individuals must stay informed about potential changes at the federal level that could influence the benefits provided by PTET.
Navigating these potential pitfalls requires a proactive and informed approach. Consulting with a qualified tax professional is highly recommended to ensure compliance with the evolving tax regulations and to maximize the advantages offered by the New York Pass-Through Entity Tax.
Conclusion:
The New York Pass-Through Entity Tax introduces a new dimension to tax planning for eligible entities. By understanding the intricacies of PTET, pass-through entities and their owners can make informed decisions that align with their financial goals. As tax laws continue to evolve, staying informed and seeking professional advice remain paramount in navigating the ever-changing landscape of state and federal taxation.
If you have any questions, please reach out to us at info@bspcpa.com or (716) 854-5034.
Written by, Jake Hooton, Staff Accountant