New York State Budget Agreement - Tax Increases & SALT Workaround

On April 6, 2021, the New York State Senate reached a budget agreement that, if signed in to law by Governor Cuomo, would result in several significant changes to the NYS tax code. While you may have seen the headlines about legalization of marijuana and sports betting, beneath the headlines there are proposed tax increases for high income taxpayers and, conversely, tax benefits in the form of a workaround to the $10,000 cap on state and local tax (SALT) itemized deductions for owners of pass through entities (including LLP’s, LLC’s and S Corporations). 

Please note that the text of the bill is still being studied and the devil is in the details, so while we are available to further discuss this email and how it may impact you, we may be light on specifics at the moment. More information will be furnished when available.  

Following are specifics with respect to tax increases and the SALT workaround.

Personal Income Tax Increases - The budget increases the current top state personal income tax rate of 8.82 percent rate to 9.65 percent for individual filers whose income is over $1 million and joint filers over $2 million. It further establishes two new tax brackets at a rate of 10.30 percent for those whose income is between $5 million and $25 million and 10.90 percent for those whose income is over $25 million. 

If you do not own a pass through entity such as an LLC or an S Corporation, and are not planning on owning one in the near future, the following section may not be applicable to you, but you are welcome to continue to read.

SALT Cap Workaround for Pass Through Entities - Under the Tax Cuts and Jobs Act of 2017 (TCJA), the Federal tax reform passed under the Trump administration, the combined itemized deduction for State and Local Taxes (SALT) was capped at $10,000. SALT includes personal income taxes such as New York State and City personal income tax and real estate taxes.  

Higher income tax states like California, New York and New Jersey were more negatively affected by this limitation. Several states tried to implement workarounds to this cap. New York previously proposed allowing taxpayers to make charitable contributions to be credited against their state income tax since charitable deductions as itemized deductions were not limited under the TCJA. The Treasury Department rejected that workaround. 

Several states including Connecticut came out with a tax on pass through entities, such as LLP’s, LLC’s and S Corporations, whereby the entity would pay a state income tax, the tax would be a deduction on the federal entity tax return reducing federal income and thereby reducing federal income tax flowing to the individual, and the taxpayer would then receive a credit from the entity to be applied against the taxpayers personal state income tax owed. The Treasury Department studied this workaround and ultimately upheld the approach. New York has now included this workaround in the above referenced budget agreement. 

To illustrate how this entity tax works, assume a taxpayer’s pass through entity nets $1 million in profit. If the profit flows to her personal return on a K-1, she would be in the top income tax bracket of 37% (previously 39.6% and set to go up under Biden tax proposals, if passed into law). If the pass through entity instead paid an entity level state income tax of 7%, then the entity would pay $70,000 in state income tax and the federal profit would go from $1 million to $930,000. At a 37% federal income tax bracket, this $70,000 deduction would save the taxpayer $25,900 in federal income tax, effectively restoring the deductibility of state income taxes limited under the TCJA. At the state level, the tax might only be a partial credit such as 90%, causing incrementally more tax at the state level. In this example if the pass through entity pays $70,000 in state tax on $1 million of profit, the taxpayer would also owe $70,000 of tax personally, less a credit of $70,000 x 90%, or a credit of $63,000, leaving a state tax balance due of $7,000. The net result of $25,900 of federal income tax saved less $7,000 of additional state income tax still leaves her ahead $16,900 on $1 million of profit. 

The details of the proposed New York law are still being reviewed and this is not yet law. For example, we do not yet know credit amount that will be available at the personal level, when the deduction is due to take effect whether commencing with the 2021 or 2022 tax year, whether the pass through tax is elective each year requiring more tax planning to determine the optimal outcome, whether single member LLC’s are eligible for the deduction (they are not in Connecticut), and more. The Biden administration is also discussing significant tax law changes that could impact the benefit of this new strategy.