New York Pass-Through Entities - Deadline for Making Election to Avoid Federal Cap on State Income Tax Deduction
In case you are not already aware, New York has established a new method for paying state income tax that allows the owners of pass-through entities, such as partnerships, limited liability companies taxed as partnerships, and New York S corporations, to avoid the $10,000 cap on state and local tax deductions for personal federal income tax purposes. Single-member LLCs, trusts, and sole proprietorships (d/b/a’s) are not eligible. However, in order to take advantage of this method, which has been approved by the IRS, the pass-through entity needs to file an election with the New York State Department of Taxation and Finance no later than October 15. The filing is made through the entity’s Business Online Services account with the tax department. If the entity does not have an account, it needs to establish one, which can be done at https://www8.tax.ny.gov/OSBZ/osbzStart.
The new law allows the pass-through entity to pay state income tax on its income and then give a credit to the owners, who can the use the credit to reduce their state income tax. Since 100% of the state income tax paid by the pass-through entity reduces the taxable income that the entity reports to its owners, not limited by the $10,000 cap, the owner gets the advantage of deducting the entire state tax bill against federal income tax liability.
For example, suppose two people are each 50% owners of a limited liability company that has $300,000 of taxable income. Under the old law, each owner would have $150,000 of federal taxable income reported on a form K-1. The state income tax, even ignoring real estate taxes, municipal taxes and other state and local taxes, would be more than $10,000, but each owner would lose the state income tax deduction on their federal tax return to the extent that total state and municipal taxes paid exceed $10,000.
However, under the new law, if the pass-through entity files an election, the pass-through entity will pay the state income tax and report net income to the owners after deducting the state income tax paid. For simplicity, let’s assume that the state income tax is $30,000, so taxable income is reduced to $270,000. The pass-through entity would also report that the owners are entitled to a credit for the $30,000 of state income tax that it paid on their behalf. Therefore, each owner would have only $135,000 of taxable income for federal purposes and the credit would wipe out each owner’s state income tax liability by $15,000.
As always when it comes to tax law, the devil is in the details. Whether a particular pass-through entity can take advantage of the new law, or whether the owners are benefited, depends upon the specific circumstances of both the entity and the owners. The deadline for electing to be governed by the new law, which is voluntary, is on October 15, only a few days away. Therefore, if you have not already done so, we urge you to consult with your tax advisor immediately to determine if you should file the election.