New York Governor proposes pass-through entity tax as a workaround to the $10,000 SALT deduction limitation

Prior to the TCJA, individual taxpayers were allowed to deduct all their state and local taxes as part of their itemized deductions.  When the TCJA was enacted, limiting the SALT deduction to $10,000, some states, including Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island, and Wisconsin, enacted Pass-Through Entity Tax workarounds to enable their taxpayers to circumvent the limitation.    The implementation of a Pass-Through Entity Tax allows the partners of the entity to pay the state tax at the business entity level, with an offsetting tax credit against their personal state income tax liability.  Because the cap on the SALT deduction only applies to individuals, the entire state tax deduction can be taken by the pass-through entity before passing the income down to its owners.  Therefore, the state and local income tax burden shifts from the individual to the pass-through entity, where they are not subject to the SALT deduction limitation.

New York State UBT bill

This recent bill, which was initially proposed and then withdrawn in 2018, comes on the heels of the IRS’s blessing of Pass-Through Entity Tax as a SALT workaround.  The proposed UBT would be applicable for all entities treated as partnerships for federal income tax purposes (excluding single-member limited liability companies, which are disregarded).

Mandatory vs. elective tax

In its current draft, New York would make the UBT mandatory.  Some of the other states have made the entity-level tax elective, allowing for flexibility in situations where it would not be advantageous to its partners.

Tax rate

The mandatory UBT will impose a 5% tax rate on partnerships doing business in the state.  Because this rate is lower than the highest tax rate for individual income taxpayers, taxpayers who are taxed at the highest individual tax rate will reap only partial benefits.  As is the case with New Jersey’s Pass-Through Entity Tax, tax rate differentials may potentially be considered as the bill is revised so that individual taxpayers can benefit from the entity level tax as intended.

Apportionment

The current draft of the proposal specifies that the UBT will be calculated based on apportioned income, using an equally weighted three-factor apportionment formula, provided for under Article 22.  This creates multiple issues.  First, the use of apportioned income creates problems for resident partners, who must report all of their income on their personal income tax returns.  In this case, the resident partner may only receive a piece of the SALT deduction resulting from the UBT tax base versus what would have been available under personal income tax rules.

For corporate partners, however, the use of the three-factor apportionment formula will potentially be beneficial, allowing them to offset additional income, which is not passed down from the pass-through entity, with the UBT credit provided.  Since the corporation’s franchise tax is calculated using a single sales factor formula, based on market sourcing, it will potentially receive a larger UBT credit from a pass-through entity, since the pass-through will use the three-factor formula.  This is generally, the case because New York-based companies tend to have wages and property more heavily located in New York than other states, plus the pass-through’s use of inception sourcing of receipts will tend to be more heavily weighted to New York than the corporation’s use of market sourcing.

Credit

Upper tier partnerships are not allowed to carry forward their UBT credits.  Instead, their individual and corporate partners are allowed to carry forward their UBT credits at their level.

For corporate and individual partners who are unable to utilize their UBT credits, if in a loss position, the credit is non-refundable, and instead may be carried forward indefinitely.  The credit is calculated as 93% of each corporate or individual partner’s respective share of the UBT, based on ownership percentage.

Limitations

This workaround provides tax relief only to individuals who earn income through a pass-through entity.  Therefore, for those individuals who earn wages, there is no mechanism to work around the state tax deduction limitation.

Additionally, S corporations and their shareholders are not specifically addressed in this proposal.  S corporations are taxed differently than partnerships, as they have different tax base and apportionment rules.  The state has also noted that S Corporations could revoke their S elections to achieve the same entity-level taxation provided by the UBT for unincorporated entities.

Mazars’ Insight

While this bill would provide relief for many individual New York taxpayers, there remain some issues that must be addressed.  We expect to know the fate of the UBT by March 31, 2021, as the bill goes through the state budget process.  Given recently released IRS Notice 2020-75, we anticipate that the draft bill will evolve to allow more flexibility for individuals to maximize the benefit of the UBT.  

Please contact your Mazars USA LLP professional for additional information.

Published on February 3, 2021

The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.