New York Pass-Through Entity Tax – Effect on the Alternative Asset Industry
One of the more significant portions of the 2017 Tax Cuts and Jobs Act [“TCJA”] to New Yorkers and residents of other high income tax states, such as New Jersey, Connecticut and California, was the limitation on deductibility of state and local income and property tax to $10,000 per return (the “SALT limitation”). Prior to the enactment of the TCJA, state and local income and property taxes were fully deductible, subject to itemized deduction limitations and the Alternative Minimum Tax.
While there has been significant discussion over the past four years of potential repeal of the SALT limitation, various workarounds have been proposed in the hope of a federal deduction. Most of these approaches, including use of the charitable donation deduction rules, have been unsuccessful. However, the concept of an entity-level tax paid by pass-through entities has been deemed to be federally deductible, pursuant to IRS Notice 2020-75, if structured properly.
Historically, certain jurisdictions have levied an entity-level tax on flow-through entities. (An example is the New York City Unincorporated Business Tax or “UBT.”) Entity-level taxes can be federally deductible and, in certain cases, allow for a credit against state and local income tax. (New York City residents, as an example, are entitled to a 23% credit of their share of UBT against their individual New York City income tax liability.)
As a result of the above notice, various states, including New Jersey and Connecticut, have enacted pass-through entity tax [“PTE Tax”] legislation. These rules either mandate or allow a pass-through entity to participate in a structure where the entity pays a federally deductible tax that is creditable against individual state income tax, essentially providing a workaround against the SALT limitation.
New York PTE Tax Legislation
On April 19, 2021, Governor Cuomo signed legislation which included the creation of a PTE Tax program. Similar to other states, the legislation allows partnerships (note that for purposes of this article, the term “partnership” includes limited liability companies taxed as partnerships) and subchapter S corporations to elect to participate. Participation creates a federally deductible entity-level tax, which then creates a dollar-for-dollar credit that members of the flow-through entity can use against their New York State personal income tax liability, essentially making the tax federally deductible.
If a partnership elects in, all income attributed to New York residents as well as New York-sourced income allocated to New York nonresidents is subject to the PTE tax. Conversely, if an S corporation elects in, only the New York-sourced income of all shareholders is subject to the PTE tax.
The PTE Tax election is an annual election, made by March 15 of the tax year, which is the due date of the first of four quarterly PTE estimated tax payments. (The remaining payments are due on June 15, September 15 and December 15.) Due to the timing of the legislation, the election for tax year 2021 can be made until October 15, 2021. Estimated taxes are paid in four quarterly installments totaling 90% of the current year’s tax or 100% of the prior year’s tax. The rate will range from 6.85% to 10.9%, based on the taxable income of the entity, to coordinate with individual New York State tax rates.
Additionally, the New York PTE Tax eliminates the concern that New York residents previously had as to whether they would receive a credit against their New York tax when participating in New Jersey or Connecticut PTE programs, as New York previously did not have a similar program. The PTE legislation specifically allows for a credit for New York residents against other states’ PTE programs if they are substantially similar to the New York PTE program.
The clear benefit is the federal deductibility of state income taxes. It is important to note that even if there is a full repeal of the SALT limitations, as some are hoping could be incorporated into the pending federal tax legislation, PTE tax plans offer the benefit that they are available whether a taxpayer itemizes or not, are not subject to itemized deduction limitations, and are not an addback for alternative minimum tax.
An additional benefit is the fact that the safe harbor for PTE payments is 100% of the prior year’s tax, rather than the 110% that is required of individual taxpayers.
Limitations to the PTE regime that may make it less than ideal include the following:
- While S corporations are able to participate in the PTE regime, similar to partnerships, they do not have the ability to specially allocate attributes to specific members.
- S corporations are limited to using the PTE rules for income that is sourced to New York State. Partnerships, on the other hand, can elect to treat portfolio income that would normally be taxed only in a member’s home state as New York-sourced income.
- The New York PTE rules appear to have been modeled after other states’ PTE rules that are already in place, and residents of New Jersey and Connecticut, for example, should be able to take the appropriate credits for taxes paid, as New Yorkers will from the New Jersey and Connecticut PTE programs. However, it is not clear how residents of other states, particularly those that do not currently have PTE programs in place, will treat their residents with regard to a credit. Note that most taxpayers would still come out ahead by taking a federal deduction even at the cost of double state tax liability.
- The tax liability of the flow-through entity is determined based on the taxable income of the entity. Therefore, entities with members that receive a small allocation of income will subject those members to a disproportionate amount of PTE tax. While the member will get a credit, the member will need to wait until they file their personal tax return, which could be in the fall of the following year, and wait for a refund.
- Partner agreements may need to be modified to allow the partnership to allocate the deduction correctly.
Effect on the Financial Services Industry
It is important to discuss the nuances of the election to management companies (i.e., investment advisors), general partner [“GP”] entities, and the funds themselves. Addressing these one at a time:
Management Companies are commonly formed as partnerships but are sometimes structured as S corporations instead. As stated above, this is a relevant distinction as the PTE tax is applicable to partnerships but not S corporations with regard to non-New York-sourced income to New York residents. Many management companies, particularly those located in New York City, do not receive portfolio income, as the fund typically has a separate entity to serve as the GP of the fund. However, the management company may allocate income out of New York (particularly with regard to fund managers working or moving out of state, which will be the subject of a different article) and, therefore, the owners of an S corporation will only be able to participate in the PTE program on a portion of their income. Regardless, in most cases it will be beneficial for management companies to participate.
With regard to GP entities, these entities are typically organized as partnerships, so the PTE election will most likely be beneficial for trades or businesses, such as trader hedge funds, as the New York resident partners will be able to utilize the PTE rules for all of their income from the entity and the nonresident partners will not be affected. (While we await further guidance, an argument can be made that entities that are not considered trades or businesses, such as the GP of investor hedge funds and private equity funds, may still be able to take the deduction.) Note that if the GP entity is owned by resident and nonresident owners, and if the allocation of income varies from year to year (for instance if the fund is a hedge fund and GP members keep a significant amount of income in the GP that is then invested into the fund, and allocated based on aggregation and capital), the computation of income subject to the PTE tax (the amount allocated to the resident partners) could be complex and difficult to compute timely.
Finally, with regard to the funds themselves, at first glance, it may be tempting for investment partnerships to make the election, in an effort to benefit their New York resident investors. In addition, fund managers often have significant limited partner investments in the fund. Concerns about liability, as well as more recent concerns regarding the carried interest rules, have made it more common for fund managers to invest a significant portion of their capital directly in the investment partnerships, as opposed to investing through the GP, as was more common in the past.
There are several reasons why this might not be a feasible approach.
- The underlying funds likely have a significant number of investors, who have different needs. It may be burdensome to deliver taxable income information to investors on a frequent enough basis to allow them to decide how much they still need to pay in New York estimates on their own.
- The allocation percentage to each partner may vary significantly from year to year, particularly with regard to hedge funds. This will make the tax computation at the entity level vary, as the fund is forced to calculate the amount of income allocable to New York resident partners, and will also make it difficult to deliver this information on a timely basis to the investors.
- It may be difficult to track the residency of each investor on a timely basis, which will be relevant to the computation of the PTE tax.
- As stated above, the deduction could potentially be limited with regard to entities that are not considered trades or businesses, such as the GP of investor hedge funds and private equity funds, although an argument can be made (as we await further guidance) that these entities may still be able to take the deduction.
- Also as stated above, partner agreements may need to be modified to allow the partnership to allocate the deduction correctly.
- Finally, and perhaps most significantly, the election would cause the tax to be a fund-level expense, reducing performance statistics and carry, which could be even more important to a fund manager than tax savings.
It is critical that fund managers, therefore, ensure that they have made an informed decision as to the election. One potential structuring option would be for investors, including the fund’s principals, to form family partnerships to house their direct investments in the fund. Note that setting up additional entities could take significant lead time and may only generate the desired benefits after setup.
As New York income tax rates continue to rise, the PTE tax may serve as relief to New Yorkers, and may keep those who are contemplating moving to a state with lower tax rates in New York. The rules may be particularly beneficial to fund managers, whose entity structure can give them the flexibility to pick and choose when to have the PTE tax apply in the best manner. Specifics on deductibility and allocations are as yet to be determined. Please reach out to your tax advisor for help in navigating the nuances of the tax.
OUR CURRENT ISSUE: Q2 2021
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