Articles & Alerts
Will you Benefit from the Expansion of the Pass-Through Entity Tax (PTET)?
Pass-through entity tax regimes – also known as “workarounds” – have been enacted by nearly half of U.S. states in response to the Tax Cuts and Jobs Act of 2017 (TCJA). The TCJA placed a $10,000 limit on the deductibility of state and local taxes (SALT), significantly disadvantaging taxpayers in high-tax states such as New York, New Jersey, Connecticut, and California.
As early as 2018, states began enacting “workaround” tax regimes that enabled members of pass-through entities to recoup some taxes at the state level to compensate for the loss of SALT deductibility at the federal level. Most of these state tax plans are similar, imposing a new Pass-Through Entity Tax (PTET) on members of pass-through entities, and allowing them a corresponding tax credit.
A few states – including New York, New Jersey, and California – have amended and effectively expanded their PTET regimes in 2022, to the benefit of taxpayers. Here’s a roundup:
New York Expands PTET
New York’s fiscal year 2023 budget contained an opportune provision that permits resident S corporations to get larger tax benefits under the state’s Pass-Through Entity Tax (PTET) regime. Under the new rules, beginning with tax year 2022, S corporations in which all shareholders are New York State residents can now remit PTET on all income allocated to the resident shareholders, rather than limiting the PTET to only New York-sourced income.
The new law was passed about a month after the PTET election due date for tax year 2022. Accordingly, only those S corporations that had previously opted into the PTET under the old law were eligible to take advantage of the rule change, as the budget bill did not modify the PTET election due date.
Consequently, many resident S corporations with low New York income allocations had not made the PTET election in March 2022, not anticipating this law change, and were thus ineligible for the new PTET benefit.
Thankfully, the legislature amended its PTET provisions to extend the election due date, making more S Corporations and partnerships eligible to elect into the PTET regime by September 15th.
Furthermore, this could be an opportunity for pass-through entities formed after the prior March 15th election deadline to opt into the tax regime.
Finally, New York has just passed new legislation which aligns certain provisions of the New York City (NYC) tax code to that of New York State (NYS) for tax year 2022 and in particular moves back the start date of the NYC PTET from January 1, 2023 to January 1, 2022. The NYC PTET is only available for partnerships and limited liability companies with NYC resident partners or members, and S corporations if all shareholders are NYC residents. Opting into the NYS PTET is required to be eligible for the city PTET election. Due to this new law change so late in the year, we are still waiting for guidance to be issued from the NYS Department of Taxation and Finance regarding how to formally make the tax year 2022 NYC PTET election.
California’s 2022 PTET Expansion Requires Careful Timing
For tax years beginning on or after January 1, 2021 and before January 1, 2026, certain California Pass-Through Entities (PTEs) can annually elect to pay a 9.3% entity-level state tax on qualified net income. Consenting qualified partners and shareholders in turn receive a state credit for their share of the Pass-Through Entity Tax (PTET), which is also deductible for federal tax purposes and thereby reduces their overall personal income tax. Qualified partners and shareholders include individuals, fiduciaries, estates, and trusts subject to California personal income tax, as well as disregarded single member limited liability companies that are owned by an individual, fiduciary, estate, or trust subject to California personal income tax.
Beginning January 1, 2022, a PTE must adhere to a special procedure to be eligible to make the PTET election. See below for some commonly asked questions and answers.
Q: What is different about the 2022 California PTET election compared with the procedure used in 2021?
A: In 2021, a PTE made its PTET election on, and remitted the applicable tax with, its timely filed income tax return. For 2022, a similar election must be made on the timely filed PTE return. However, prior to the 2022 tax return’s filing, an estimated PTET payment must be made.
Q: When must this PTET payment be made?
A: For tax years 2022 through 2025, an electing California PTET must make two payments. The first payment (for the greater of 50% of the PTET paid for the prior year, or $1,000) must have been made by June 15 of the taxable year for both calendar year and fiscal year PTEs. The second payment must be made by the PTE’s filing deadline without extensions (March 15 for calendar year taxpayers).
If the June payment was underpaid or not paid, the PTE will be ineligible to make the election for that taxable year. There are currently no exceptions to this rule, even if a PTE anticipates its 2022 PTET liability to be less than 50% of its 2021 liability.
If a PTE underpaid the June 15 estimate and does not qualify for the 2022 PTET, any funds that were paid in but not utilized for the PTET can be claimed as a refund in the PTE’s 2022 tax filing.
Q: What should a PTE do if it did not elect into the 2021 PTET and therefore had no elective tax due for the prior year, but is nevertheless considering opting in for 2022?
A: The PTE must have made an estimated June 15 payment of $1,000 to retain its eligibility to elect into the 2022 California PTET.
Q: Can the June 15 PTET estimate be considered by a PTE’s consenting shareholders and partners when calculating their personal second quarter tax estimates?
A: While PTET estimates are technically not considered estimated tax payments on behalf of a qualified shareholder or partner, they may result in a decrease in the owner’s ultimate California tax liability, which results in reduced estimated tax payment amounts. Therefore, if the June 15 payment reflects a PTE’s actual 2022 PTET, the payment can be factored into an owner’s projected estimated taxes due. A note of caution — if the June 15 estimate is anticipated to be more than the 2022 PTET liability, one may not want to reduce an owner’s estimates based on this payment because any excess PTET payments will be refunded to the PTE and will not pass through to the owner, resulting in an underpayment of California taxes.
New Jersey’s BAIT Expanded
New Jersey’s Business Alternative Income Tax (BAIT) regime was modified recently to enhance its tax benefits. The BAIT is an elective entity-level tax which serves as a workaround to the $10,000 federal cap on state and local tax deductions. Internal Revenue Service guidance provides that state pass-through entity taxes (PTETs) are fully deductible as a business expense at entity level, thereby reducing federal taxable income, and can also be applied as a credit against a partner’s or shareholder’s personal state income taxes.
While many pass-through entities have opted into the BAIT since its inception in 2020, the new law may induce more of the state’s PTEs to consider election for the 2022 tax year. Specifically, the following changes became effective on January 1, 2022:
- The method of calculating BAIT was modified so that more income is subject to the tax, thus enabling a larger credit to be obtained. Under the revisions, a partnership’s distributive proceeds upon which the tax is computed now includes both in-state and out-of-state income for resident partners. Previously, the elective tax was calculated only on New Jersey-sourced income. Under the rule change, New Jersey resident partners, who are subject to New Jersey gross income tax on all income wherever sourced, can now have the BAIT applied to all their allocated partnership income resulting in a larger BAIT credit. Note that this change is limited to partnerships and does not apply to S corporations, which must continue calculating their BAIT on New Jersey-sourced income only.
- The BAIT tax brackets are now updated to closely align with the recent changes to the state’s gross income tax brackets that went into effect in 2020.
- The treatment of BAIT overpayments is modified so they can be applied to the estimated tax liability in the subsequent year as opposed to only being refunded.
- The changes also provide that pass-through entities do not need to make nonresident withholding payments on behalf of a nonresident partner if the nonresident expects a refund of the withholdings as a result of the BAIT credit.
- Furthermore, a BAIT credit will be permitted for tiered partnerships and S corporations that are partners in partnerships. Such credits can be passed through to the partners or shareholders or applied against the tax liabilities of the partnership or S corporation and its BAIT liabilities.
These are welcome changes to the BAIT regime, particularly for New Jersey resident partners who stand to benefit from the increased credits available to them. Additionally, aligning the BAIT rates to the state’s gross income tax brackets will further ensure that taxpayers maximize the value of electing into the tax.
Connecticut’s PTET Law Remains Unchanged
Connecticut’s pass-through entity tax was enacted in 2018 and was one of the first state “workaround” laws designed to blunt the impact of the $10,000 limit on SALT deductibility contained in the TCJA. It has not been significantly modified since passage.
Connecticut’s law, known as PET, works much like similar laws now in effect in nearly half the states, by requiring pass-through entities to pay tax at the entity level and providing an offsetting credit against individual income and corporate taxes.
One notable difference about Connecticut’s PET regime is that it applies to all affected pass-through entities and does not require an election. Affected entities include partnerships, S corporations and LLCs treated as either S corporations or partnerships for federal income tax purposes. Publicly traded partnerships are excluded from PET.
PET calculation
The primary elements of the PET calculation for an affected business entity are as follows:
- Separately and non-separately computed items derived from or connected to Connecticut sources as determined by the sourcing rules that are currently applied to the Connecticut income tax;
- Adjusted by applicable Connecticut state modifications;
- Multiplied by 6.99%.
If the affected business entity’s PET calculation results in a loss, the entity may carry the loss forward until it is fully utilized.
Credits and overpayments
Individual and corporate members of affected business entities are entitled to an offsetting credit against their respective taxes. The credit is 87.5% of the member’s direct and indirect pro rata share of the tax paid. For individuals, any portion of the credit exceeding their tax liability is treated as an overpayment and eligible for a refund. Credits for corporate members shall be applied only after all other available credits are used but are not otherwise restricted by the general limitations on how much liability can be offset. Corporate members carry forward any unused credits indefinitely.
Non-resident taxpayers are not required to file Connecticut income tax returns if their Connecticut income is derived from membership in affected business entities that file and pay the PET. A filing obligation may still exist, however, if the member’s affected business entity elects to file its return on a combined basis and the nonresident’s Connecticut income tax due would not be fully satisfied by the credit generated by the PET.
Due dates and estimated tax installment payments
Four equal estimated payments are due throughout the year, the deadlines being determined by the entity’s fiscal year.
Each estimated payment must be 25% of the required annual payment, and the sum of the four estimated payments must be equal to the lesser of 90% of the current year PET due or 100% of the PET paid during the last 12-month taxable year where a PET return was filed.
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How Anchin Can Help
For more information on these states’ PTET regimes, and the upcoming New York PTET rule changes and how they may be applicable to you, please contact Alan Goldenberg, Principal and Leader of Anchin’s State and Local Taxation and Tax Controversy groups, or your Anchin Relationship Partner.