The limitation on the deductibility of state and local taxes (“SALT”) at $10,000 was part of the Tax Cuts and Jobs Act back in 2017, and, without pointing fingers, it seemed to many like it may have been taking a shot at blue states (that tend to have higher state tax rates than red states). Several of these states, such as Connecticut and New Jersey, have found ways to fight back against the SALT limitation that was leading to higher federal taxes for many of their residents. In late 2020 the IRS released a notice explicitly stating that they were okay with the types of workarounds set up by CT and NJ, and now that they’ve gotten the green light, New York is following suit with a workaround of its own.
Why does the SALT limitation matter?
When you file your personal tax return, it includes all of your taxable income and, if you itemize, all of your deductions. One of these deductions is the total of the state and local income taxes you paid during the year (and some non-income taxes like property taxes). Prior to 2017’s TCJA, you were able to claim a deduction for all of the SALT that you paid during the year, however, the TCJA imposed a limitation such that only $10,000 of SALT can be deducted on a personal tax return, sharply reducing the total deductions for some taxpayers.
How does New York plan to work around this limitation?
New York’s plan, similar to that of some of the earlier adopters, is to basically convert personal SALT (such as your New York income taxes), which are subject to the $10,000 cap, into business SALT, which is deductible in full as a business expense and is not subject to any cap.
Who does this workaround work for?
- Pass-through entities such as partnerships (including LLCs taxed as a partnership) that file New York tax returns because they either have New York-sourced income or have a partner that is a New York resident
- New York S-Corporations
What do I need to do to take advantage of this option?
Starting with tax years that begin on or after January 1st, 2021, the pass-through entity can make an annual election to opt into the pass-through entity tax, which is irrevocable for the year and must be made by the due date of the first estimated tax payment (which is generally March 15th). Seeing as March 15th has already passed for 2021, we expect the commissioner of taxation to release guidance regarding making this election for 2021.
Once you elect in, the entity is now responsible for paying income tax to New York State (a pass-through entity that does not opt in would not owe any income tax to New York State for the year).
So my entity has now paid pass-through entity tax to NY, how does this help me?
Your entity will still issue you a K-1 reflecting your New York income, which will be taxed on your personal tax return. However, for every dollar of income tax that your entity pays to New York State, you will receive a dollar of New York tax credit. This means that your entity is effectively paying your New York state income tax on your behalf, but without being limited to how much of the tax it is allowed to deduct. The unlimited deduction available to the entity for the taxes paid will reduce the entity’s taxable income, so you’ll be taxed on a lower amount (we’ll go over an example outlining this later in the article).
How is the tax calculated?
The same way that the NY personal income tax is calculated (but only on the pass-through entity’s taxable income), so you’re not paying more tax this way than you would have if you opted not to make this election. Note, however, that New York City tax is not included in the pass-through entity tax.
What if the entity pays in more tax than I end up owing on my personal return?
No problem! You can get the excess refunded to you.
An example:
For simplicity in these examples, let’s assume that you file a joint tax return with your spouse, that your federal tax rate is a flat 30%, and that the NY tax rate is a flat 6.85%. Your only income comes from your S-Corp. During the year you paid:
- $15,000 of real estate taxes
- $14,000 of mortgage interest
- $2,000 of charitable contributions
Without electing to utilize the pass-through entity tax:
- Big Apple Inc., your NY S-Corp, generates a $100,000 taxable profit in 2021
- Big Apple, having not elected to pay the entity-level tax, does not pay any income tax to NY
- Your K-1 reflects your $100k of taxable income
- Your itemized deductions total to $26,000 (made up of $14k of mortgage interest, $2k of charity, and SALT limited to $10k because of the cap)
- After your deductions your federal taxable income is $100,000 – $26,000 = $74,000, which is taxed at 30%, making your federal tax $22,200
- You pay personal NY income tax on the S-Corp income at 6.85% (ignoring deductions for the sake of simplicity here)
If you elect to utilize the pass-through entity tax, things are a little different:
- Big Apple Inc., your NY S-Corp, generates a $100,000 taxable profit in 2021
- Big Apple pays the pass-through entity tax to NY at a rate of 6.85%, so $6,850. This is a deductible expense to the company, so it’s taxable profit after the NY entity tax comes down from $100,000 to $93,150
- Your K-1 reflects your income of taxable $93,150
- Your itemized deductions are unchanged from the previous example. Even though your NY tax is now being paid for by the corporation, your real estate taxes alone are more than $10,000, so you still have itemized deductions totaling to $26,000
- After your deductions your federal taxable income is $93,150 – $26,000 = $67,150. This is the real power of this program! Your taxable income is $6,850 lower than in the previous example, which is the amount of NY entity-level tax paid by Big Apple Inc. You’ve deducted this NY state income tax by effectively sidestepping the $10,000 SALT limitation!
- The $67,150 is taxed at 30%, making your federal income tax $20,145
- You incur personal income tax on the S-Corp income at 6.85%, however, because the S-Corp passes you a NY tax credit of $6,850 for the entity-level tax it already paid, you don’t have to pay anything to NY with your personal tax return, so from a state perspective you’re in the same place, financially, that you were in our first example (just via slightly different mechanics)
So what’s the outcome?
The additional $6,850 deduction caused your federal income tax to come down from $22,200 to $20,145, a savings of $2,055! How much would your savings have been if your S-Corp’s profit was $1,000,000?
Your NY income tax is basically the same, just paid to the state from a different entity (your S-Corp instead of from you personally).
Other than making the election, what should I do to maximize my tax savings?
- If you’re not currently operating as an eligible entity (e.g. you are a sole proprietor or single-member LLC that reports your income on Schedule C on your personal tax return), consider changing your status. One option would be to elect to have your single-member LLC taxed as an S-Corporation, however, you should consider all of the various effects this may have on your tax situation
- If you have the option to shift your S-Corporation’s income between wages and pass-through income, you may want to opt to have more of it taxed as pass-through income so that it qualifies for the entity-level tax. Remember, the NY income tax withheld from your wages will still be subject to the $10k SALT limit, so minimizing this to the extent possible would be beneficial
What don’t we know about the pass-through entity tax?
There’s a lot we’re still waiting for guidance on from the state, largely related to administrative tasks, such as:
- When/how to file the election, especially for 2021 since the due date of March 15th has already passed for the year
- What happens to NY estimated taxes already paid by individuals for 2021? Can they be transferred to the company’s pass-through entity tax account (like we did when Connecticut first implemented their pass-through entity tax)?
- What forms will have to be filed for the pass-through entity tax?
In conclusion…
This is a big win for New York small business owners looking to minimize their federal tax burden. If you’re not sure if you qualify or you think you may be able to qualify with a few adjustments to your structure, let us know, we can help you navigate this new and complex opportunity for your business.
This is a new and changing area of the New York tax code. Always consult your tax advisor before making any decisions based on the topics covered in this article.