Pass-Through Entity Tax (PTET) for Law Firms

As Seen in Anchin’s Law Firm Year-End Planning Guide

The state and local tax deduction was limited to $10,000 for tax years after 2017 under the Tax Cuts and Jobs Act. Taxpayers in high tax states lost a significant deduction that reduced their federal income tax liability.

Some high tax states proposed various work-arounds to provide residents with a way around the $10,000 limitation. The most popular work-around was to impose a tax on pass-through entities where the owners of the pass-through entity would receive a credit on their individual returns offsetting the tax liability due on the pass-through income. In turn, the pass-through entity would deduct the state taxes paid thereby reducing the federal income ultimately passing through to the partners/shareholders.

In November of 2020, the IRS issued Notice 2020-75, clarifying that a pass-through entity would be entitled to a deduction equal to the state taxes paid to a state for an entity tax where the partner or shareholder would receive a credit of up to 100% that would reduce their state tax liability by the amount of taxes paid. With the release of this Notice, some 36 states and New York City have passed or proposed their own PTET regime. California, Connecticut, Massachusetts, New Jersey, New York and New York City have, to name a few. Each of these has different requirements to participate as well as different methods of calculating/utilizing the PTET credits.

• New York State (“NYS”) PTET. To participate in NYS’s PTET for 2024, the pass-through entity was required to file an election prior to March 15, 2024. NYS has different methods of calculating the tax for a partnership and a “resident S corporation” (all NYS resident shareholders) than it does for an S corporation with both NYS and non-NYS resident shareholders. Partners and shareholders who receive an allocation of the NYS PTET credit will be able to offset their NYS (and NYC if applicable) tax liability with any excess eligible to be refunded. Please refer to our earlier Anchin Alert for more details on the NYS PTE Tax: (https://www.anchin.com/news/anchin-alert-new-york-provides-clarity-on-the-new-pass-through-entity-tax-an-opportunity-for-tax-savings).

• New York City (“NYC”). The NYC PTET is only available for partnerships with NYC resident partners and S corporations of which all shareholders are NYC residents. Nonresidents of NYC will not receive any benefit under the regime because the NYC personal income tax only applies to City residents. The NYC election is now available online; however, opting into the NYS PTET is required to be eligible for NYC’s PTET election. Please refer to our earlier Anchin Alert for more details on the NYC PTE Tax: (https://www.anchin.com/articles/official-guidance-on-the-nyc-pass-through-entity-tax/).
  
  • Estimates. For both the NYS & NYC PTET regimes, estimates must be made in 4 equal quarterly installments based upon 100% of the prior year liability or, 90% of the current year liability. Annualization is not allowed within the PTET regime, and this creates significant challenges for firms with significantly changing income throughout the year.

• California PTET. A PTET election is made on the entity’s tax return. For tax years 2023 through 2025, an electing CA PTE must make two payments. The first payment for the greater of 50% of the PTET paid for the prior year or $1,000, must be made by June 15th of the taxable year for both calendar year and fiscal year pass-through entities. The second payment must be made by the pass-through entity’s filing deadline without extensions. If the June 15, 2023 payment was underpaid or not paid, the entity is not eligible to make the election for the 2023 tax year. There are currently no exceptions to this rule, even if an entity anticipates its 2023 PTET liability to be less than 50% of its 2022 liability. Please refer to our earlier Anchin alerts regarding the CA PTET for more details: (https://www.anchin.com/articles/what-you-need-to-do-now-to-be-eligible-for-californias-2022-ptet/, https://www.anchin.com/articles/will-you-benefit-from-the-expansion-of-the-pass-through-entity-tax-ptet/)
• New Jersey (“NJ”) PTET. Tax year 2022 also saw law changes to enhance New Jersey’s version of the PTET known as the Business Alternative Income Tax (“BAIT”). Specifically, the law modifies how the BAIT is calculated 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 include both in-state and out- of-state income for resident partners. 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. Finally, 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. For additional information on these NJ changes, please see our Anchin Alert: (https://www.anchin.com/articles/new-jerseys-bait-updates-provide-an-even- greater-tax-benefit/).

While the benefits of the PTET can be significant, before deciding to participate in a PTET, careful consideration should be given to where the owners live. If they are a nonresident of the state where the pass-through entity is domiciled, it is possible that their resident state would not allow an offsetting credit equal to the tax paid in the nonresident state (the PTET state).

The impact on other tax attributes, such as the IRC Section 199A 20% pass-through entity deduction (if applicable), and the cash situation of the pass-through entity should also be considered.

Further, one should factor in potential PTET refunds which are generally taxable for federal income tax, as well as the economics of opting in specifically due to the rate differential between the PTET and the partners’ individual income tax rates.

*Practice Tip: Firms should be certain their operating agreements provide for the flexibility necessary for the PTET regimes. Planning should be done in advance to address withholding from partner/shareholder distributions to facilitate payments of PTET estimated taxes and the timing related thereto, and finally, true ups will be needed upon the filing of the actual PTET returns based upon individual credits vs. deductions.