Seasoned Conversations with SALT - Episode 4
KPMG State and Local Tax (SALT) partner, Jeff Burns continues the Seasoned Conversations with SALT video series with SALT Managing Director, Aaron Shafer.
In this episode Jeff and Aaron discuss the recently passed New York Pass-through Entity Tax (PTET). Aaron covers the procedural nuances and complexities of the calculation with a broad conversation on other states employing a similar model.
Jeff Burns: All right. Well, hey, welcome back to another episode of Seasoned Conversations with SALT. Again, I’m Jeff Burns, partner with KPMG. Today I’m joined by Aaron Shafer, a managing director out of New York in our Financial Services practice. Aaron, welcome to the show.
Aaron Shafer: Thanks for having me, Jeff.
Jeff: Yes. No, I appreciate you jumping in. You and I were talking, and we’re going to kind of twist this a little bit from some of our prior episodes, and we’re going to go straight technical on this which I think is great because the topic that we’re covering is extremely important, and we want to make sure we dive into this a little bit. So Aaron, where I’m going to start is what we wanted to cover was the New York pass-through entity tax or PTET.
We’re hearing a number of other states have also instituted PTETs. Can you walk me through what is a PTET, and how does it work?
Aaron: Sure. As a result of the last tax reform, the personal deduction for state and local taxes federally was capped at $10,000. So at that point, a number of states, high-tax states, passed so-called workarounds for mechanisms to provide a higher deduction. Many of those were shut down as being too gimmicky, but pass-through entity taxes, that is, a tax on a partnership-type entity that then provided a credit to the partners, was blessed by the IRS at the end of last year as being a good business deduction. So the entity gets a deduction, lowering the federal taxable income going out to the partner, and that is a workaround for the $10,000 cap on the personal income taxes.
Jeff: Interesting. So just to clarify. The IRS has weighed in that this is actually a good deduction?
Aaron: That’s correct. Some of the other schemes that states came out with like charities and so forth, the IRS weighed in and said we’re not going to recognize that. But they analyzed this type of mechanism and did bless it in saying they will recognize it as a good federal business deduction at the partnership.
Jeff: Interesting. So here we are. It’s May, almost mid-May at this point. We’re in the height of tax season for many folks. What’s the first year that the New York PTET is going to apply?
Aaron: Right. So a few other states especially around New York, Connecticut and New Jersey, passed them previously. New York passed it as part of its most recent budget, and so the first year is tax year 2021. They passed the budget late in the season, and so the timing mechanism is a little bit off in this transition year. So it’s a purely voluntary tax to participate, and so you elect into it. New York provides that you elect by March 15th of the tax year, but obviously we’re past that now, and so for this transition year, the election has to be made by October 15th, and no payments are due by the partnership until after October 15th.
Jeff: Okay, so that covers the partnership, but what about the partners? Do they still need to make their quarterly estimated payments?
Aaron: Yes. Again because of this transition year and because the budget was passed late, the partners are required to continue making their quarterly estimated payments at their level just as they would normally, and then the partnership will elect into it if they choose to, and then it will have to make a payment by yearend so that you get the federal deduction in tax year 2021. As a result of that, though, the partnership’s going to pay the tax, and the partners have been paying the tax.
You will be double paid in this transition, but that’ll come through as a refund to the partners on their return. They’ll just be overpaid like can happen. Going forward, when the partnership elects on March 15th to participate, the expectation is that will alleviate the partners from having to make estimated payments at their level because then the partnership will be required to make the quarterly estimated payments. So you have a bit of a transition year issue with some double payments, but it’ll come through on the refund.
Jeff: Interesting. We see this happen sometimes when you have transition periods for tax, so I appreciate you walking through. That’s a bit of process that I think a lot of individuals and the partnership itself need to be aware of. You hit on it a little bit. We’ve talked about the process. We’ve talked about what’s been implemented. How’s the tax actually calculated, associated with this?
Aaron: Right. So it functions just like withholding credits that partnerships and partners are probably used to; that is, tax payment is made at the partnership level. They pass up a credit that then the individual partner applies at their level. So the way the tax is calculated for New York state residents who pay tax to the state of New York based on simply being a resident of the state, and they’re taxed on all of their income, the tax base for New York state resident partners is all of the income they get out of the partnership. There’s no distinction between New York State source income or any of that. For nonresident partners, it is the New York state source income based on the apportionment applied at the partnership. So as a nonresident, you’re used to getting your New York state K-1 which reflects your New York state source income that you’d be liable to pay for as a nonresident.
So for those nonresidents, the same thing. That goes into the tax base of the partnership. For residents, it’s all of their income. You sum that up for each partner, and you can’t pick and choose. If the partnership elects, all the partners are in. It’s not like a composite where you can select who’s in and who’s out. So you sum that up, and then the partnership pays tax on that with the graduated rates under the New York state personal income tax.
So if you think about it, New York state, also as part of the new budget, passed these higher rates. There’s a new higher rate for about five million and then above 25 million. So when the partnership adds up those amounts from the residents and nonresidents, it could very well be in that top over 25 million bracket. But then when you distribute out the income, each partner might be in a lower bracket, under 25 million, under five million and so forth, and so there’s a bit of a play between those rates, and that’s going to affect the credit amount. Like I said before, any excess credit is refundable at the partner level.
Jeff Burns: So it sounds a bit complex, but I think that’s certainly where we’re going to be assisting our clients in that process, because it does sound like a very complex calculation, but I think the end state seems to be benefit more of the high-net-worth taxpayers, and as I think about that calculation, I think about the mechanism to provide for the credits, what’s the benefit to the state of New York, and why would they have put this in this recent bill?
Aaron: That’s right. So they put it in. There was pressure around high-net-worth people leaving the state. That was true before COVID and now, with COVID, people realizing they can work kind of anywhere, and so there is a fear of that. Connecticut and New Jersey passed one of these workarounds. So there’s also pressure on New York kind of coming from both sides, and so the benefit to the taxpayer is on this federal deduction, and states have figured out that they can actually get more tax dollars paid to the state which taxpayers are willing to pay because there’s still a net benefit from that big federal deduction.
So what New York does is you have to pay tax on the credit, and so the way that works is you have your federal income, but this PTET is a deduction. So you have to add that back when you do your state taxes, so now you’re kind of flat, and then you add back the amount of the credit. It’s almost like a double add-back. So that increases the tax base for New York. So you’re paying more tax dollars to the state of New York because of that double add-back.
That’s far been outweighed by the federal deduction. So New York is actually being paid. It benefits because you’re paying the state of New York more in taxes to get the federal benefit, and we’ve seen that in other states. For instance, Connecticut doesn’t give you 100 percent of the credit. It gives you 87.5 percent of the credit, so then Connecticut benefits because you have to pay in that additional amount at the individual level.
New York, same thing. Because of the double add-back, the credit isn’t going to quite cover most likely your personal tax liability, and you have to pay in more but, like I said, you’re happy to do it because that’s the price to get the federal deduction. So New York comes out ahead.
Jeff: Understandable. So we’ve laid out the benefits to the individuals and to the partnership. We’ve laid out the benefits to the state, and I think you touched on this a little bit, but if the partnerships got residence of another state, do those residents in the other state, do they typically get a credit in the home state for state taxes paid to another, and how does that work with the PTET? Do they get that credit in their home state then?
Aaron: Yes. So if the PTET wasn’t part of the picture, a nonresident paying taxes to the state of New York would get a credit in their home state against that liability to try to avoid too much of the double taxation. So a question is raised. If now the tax is being paid by the partnership rather than the individual, would you get a credit in your home state? So states that have passed their own PTET – there’s about ten states out there, and there’s draft legislation in some other states – provides that, okay, if you’re paying a similar PTET tax in another state, we’ll certainly give you credit in the home state.
Other states have unofficially said, okay, we will recognize that because we understand what’s going on. Other states have simply said, no, we’re not going to recognize that. So you mention it is complex, and there’s some modeling and planning, and we do extensive models with our clients to see what’s the all-in effective tax rate to the partners by doing a PTET, not doing a PTET, resident, nonresident, and so if the don’t get that home state credit, that goes into the model. You might have the interests are in alignment between resident partners who want to do it. Nonresident partners might not benefit then, and so they don’t want to be involved. Then there’s a bit of a conflict.
Jeff: That’s interesting, and I guess one thing just to touch on when you say there’s a bit of a conflict, and I know you had mentioned earlier that it’s almost an all-in concept. So using those calculations, is that part of the process to then say we have to get collective agreement on this between resident and nonresident partners?
Aaron: Yes. So you really do. You want to model it out, because you don’t want to inadvertently put someone in a worse tax position when you’re actually trying to benefit them. So the New York legislation, it’s kind of the latest out of the gate. So it’s looked at the other states and kind of improved upon them, so it's quite flexible in the way you’re able to use it. Let’s say you have your partnership with your mix of partners. You can create a partnership above that for let’s say your New York state resident partners. Put them all in there.
This partnership would then just flow up the income to that, and then that partnership can make the PTET election. So then it would be isolated just to the New York state resident partners to avoid this issue of other partners maybe not being able to get the credit in their home state or whatever their personal income tax situation may be when we model it out. So you can create let’s say sleeves of partnerships for who wants to participate and who doesn’t.
Jeff: Interesting. Yes, and I think that makes sense, and it’s something that a lot of our clients should be considering as we think about what are the impacts of the PTET. So as we round this conversation out, I’ll ask you one final question. Is there anything that you’d want to leave everyone here with as we round out the conversation on New York and some of the other states we’ve talked about with respect to PTETs?
Aaron: So the way that the tax is calculated and what allows a partnership to do a PTET, so other states – looking at Connecticut right next door – you’re required to be engaged in a trade or business in Connecticut or have Connecticut state source income. New York doesn’t require that, and that’s what I mentioned. New York has a lot more flexibility. You can just be a partnership, and all you’re required to have in New York is a partner subject to the personal income tax. So that’s an individual, trust or estate. If you have a partnership partner or a corporate partner, you’re not disqualified. You just don’t calculate tax on those partners. So Connecticut, you have to be involved in a trade or business, and it’s limited to Connecticut state source income. So like I said, for New York the nonresidents, it’s the New York state source income.
Connecticut, it’s the state source income whether you’re a resident or not. So if you think about it, if you’re a Connecticut resident and you pay taxes on all of your income, you’ll only get the benefit of the PTET to the extent the partnership has Connecticut state source income which might be significantly less than your entire income. So then what’s the benefit of going through this whole exercise? So that’s where New York looked at that and said we’re going to try to be as flexible as possible. So New York provides that flexibility with an eye towards the partner need to determine their federal deduction eligibility.
Other states said, okay, we’re going to be pretty strict to try to really fall in line with what we think would qualify for a federal deduction, and New York seems to have the attitude we’ll be really flexible. You will be able to do this PTET whether you qualify for a federal deduction under a good business expense for a partnership that isn’t involved in a trade or business. That’s up to the partnership to figure out, but New York provides that flexibility, and it’s still a new area and so, as I said, the IRS came out with that notice at the end of last year. So how it’s applied is still an open issue, and further regulation and guidance should be forthcoming.
Jeff: Perfect. Well, Aaron, this was extremely helpful. Clearly you have a lot of knowledge on the topic, and I think it’s very clear there’s a lot of complexities around it but some opportunities to help our clients with thoughts around how you handle residents versus nonresidents and the application therein. So Aaron, I appreciate your time today. Thank you for joining me on another episode of Seasoned Conversations with SALT, and we’ll look forward to talking with you soon.
Aaron: Thanks, Jeff.
Jeff: Thank you.