N.Y. Considering Business Tax Workaround to Federal Deduction Cap

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By Gerald B. Silverman

New York is taking the next step in its effort to revamp its tax code to preserve the federal deductibility of state income taxes in response to the new federal tax law.

The Department of Taxation and Finance issued a proposal May 16 to create a 5 percent unincorporated business tax (UBT) on partnerships and a corresponding personal income tax credit to ease the tax burden on certain pass-through entities.

Pass-through entities are businesses in which the profits, and income tax liability, pass to the owners of the organization, such as to the individual partners of a partnership.

The department’s proposal will need legislative approval, but isn’t likely to be considered by the state Legislature before it adjourns its 2018 session June 20. The department has opened the proposal for comments until July 16.

The proposal would mark another significant change to the state tax code, which was overhauled earlier this year with two “workarounds” to mitigate the impact of the $10,000 cap on the federal deduction for taxes paid to state an local governments. New York became the first state to create a payroll tax and two charitable funds as workarounds to the 2017 federal tax act ( Pub. L. No. 115-97).

Filling the Gap

The two workarounds, however, left a gap because some of the state’s wealthiest taxpayers are members of partnerships and don’t have wage income. The highest-earning 1 percent of state taxpayers generate about 40 percent of its personal income tax receipts, according to E.J. McMahon, research director at the conservative-leaning Empire Center for Public Policy.

“The group of New Yorkers with by far the most to lose from the SALT cap are the best-compensated members of its most lucrative investment partnerships and law firms, which are excluded” from the federal tax law’s “big tax break for partners in pass-through firms,” McMahon said in a May 16 blog post.

“Partners in these firms, based mainly in New York City, are the core of the Empire State’s highest-earning 1 percent, on whom the state has become increasingly dependent for an outsized share of tax revenues,” he said.

The state’s draft proposal would levy a 5 percent UBT on partnerships as defined by the Internal Revenue Code, including limited liability companies treated as partnerships for federal income tax purposes. Partnerships could then claim a credit against their personal income tax equal to 93 percent of the UBT.

Aaron M. Young, a partner at Reed Smith LLP, said it’s unusual for a state to have a UBT. New York would continue to take a leadership role in tax policy, as it has with its two previous tax workarounds, he said.

“New York is trying to capture all of the business activity, not just from a corporate perspective, which most states don’t do,” he told Bloomberg Tax.

Young predicted that the final proposal would probably cover other entities besides partnerships and might also include a minimum threshold for which taxpayers would be subject to the UBT.

Key Questions Remain

Many questions must be answered before the plan is finalized, according to the department. A summary of the plan, for example, asks for public comments on:

  •  the tax base to which the UBT should apply;
  •  the entities to which the UBT should apply, including the potential inclusion of S corporations;
  •  the appropriate tax rate for the UBT;
  •  whether to exempt income below a certain threshold;
  •  whether any categories of income should be exempt; and
  •  whether the UBT should be optional or mandatory.

New Revenue Source?

Peter L. Faber, a partner at McDermott, Will & Emery, said the business community has concerns that the UBT tax, once enacted, could be increased and used in the future as a new revenue source for the state. Faber told Bloomberg Tax that a number of provisions in the proposal need clarification.

He said, for example, that the tax wouldn’t be limited to income from an active business but might also apply to investment income. “Would it be possible for individuals to place passive investments in a partnership so as to get the benefit of a federal tax deduction for taxes paid on the resulting income?” he said in an email. “Could this be done by spouses filing a joint income tax return?”

Faber also said there are questions related to apportionment. “The tax would apply only to a partnership’s New York income, determined under an apportionment formula based on the partnership’s property, payroll, and sources of income,” he said.

“The payroll factor is based on compensation paid to ‘employees,’ and presumably will not apply to compensation paid to partners,” Faber said. “This could be distortive because so much of a professional partnership’s income is attributable to services performed by the partners. Could a New York professional partnership reduce its tax liability by having its administrative employees work in New York or Connecticut?”

To contact the reporter on this story: Gerald B. Silverman in Albany, N.Y., at gsilverman@bloomberglaw.com

To contact the editor responsible for this story: Ryan C. Tuck at rtuck@bloombergtax.com

For More Information

More information on the proposal is at http://src.bna.com/yS8.

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