Recent changes in the federal state and local tax (SALT) deduction are having a ripple effect in New York and several other states. This may impact your freelance business, because New York State (NYS), among others, is now instituting a new irrevocable pass-through entity tax to offset the shortfall they are experiencing on revenue from SALT as a result of the Tax Cuts and Jobs Act (TCJA) of 2017.
In many states, especially those with higher-than-average property taxes, like New York, the SALT deduction cap of $10,000 from the TCJA changes resulted in a tax increase (due to a reduced deduction) even for mid-income individuals who itemized these taxes. As such, the state experienced a revenue reduction, inspiring the need to replace the revenue with the new optional pass-through entity tax.
If you operate a business as a partnership or if you are considering selecting this entity type for your business in New York, the new tax will affect you directly. Whether the impact is positive or negative depends on a number of factors that we summarize below. You should also think about how comfortable you are permanently opting to itemize your state and local taxes at the entity level each tax year.
How freelance businesses may be affected by the new pass-through entity tax
The new pass-through tax election was made effective January 1, 2021, and will remain in effect unless it is changed by legislation. As noted previously, the pass-through tax is an optional election by partnership and S-corporation (S-corp) entities, and it is irrevocable after the election is made for each tax year. You can read the related IRS Notice 2020-75 here: https://www.irs.gov/pub/irs-drop/n-20-75.pdf.
New York (and other states) are taxing income from partnerships (multi-member LLCs) and S-corps, but not single-member LLCs at lower rates than would occur if they were taxed at the owners’ individual tax rates, if the owner chooses to apply the new pass-through tax to their qualified business income.
Factors to consider before you elect into New York’s new pass-through entity tax
Before you decide to elect into the new pass-through entity tax, it is important to understand how it affects your business, because the impact depends on the type of business entity you have and whether or not you choose to itemize your SALT.
· Opting into this tax change may not be in the best interest of some NYS taxpayers because the state charges higher tax rates for taxpayers who have lower incomes and are in lower tax brackets, This is especially so if you don’t itemize your deductions. In these cases, it may actually be a disadvantage to opt in.
· This is an optional tax deduction, but you must elect to take it each tax year if you choose to take advantage of it.
· Although the taxes are paid as a part of an entity owner’s individual income tax return, the pass-through income is not subject to tax at the individual’s rate, thus no double taxation, and a potential net savings for the business owners.
· The taxes paid on the pass-through entity income are deductible and not subject to the $10,000 SALT cap.
· If you determine it would be advantageous to itemize your SALT at the entity level but you are a sole proprietor with a single-member LLC, you can set up a multi-member LLC or an S corporation to benefit from the pass-through entity tax changes.
· You must make the irrevocable election to go this route by the first estimated payment due date (March 15) of the calendar year prior to the year in which your tax return is filed.
· The election is made annually and is effective for the current taxable year. For the 2021 tax year only, an election must be made by Oct. 15, 2021.
· You must also make four equal estimated tax payments for every quarter of the calendar year of the lesser of 90% of the current year tax or 100% of prior year tax. For the 2021 tax year, estimated payments are not required.
What is considered qualifying income for the pass-through entity tax?
Essentially, if you have a pass-through business, you can pay additional state tax from your company entity, then claim the offsetting credit against your individual income tax liability, since the SALT deduction cap does not apply to business taxes.
Therefore your entity-level tax will assess a liability directly on your business before the income passes to you as an owner.
In New York state, qualified income for this offset credit includes income paid to partners/shareholders, including individuals, trusts, and estates at the rates below.
Pass-Through Entity Tax Rates
Income Level | Rate
· Under $2,000,000 = 6.85%
· $2,000,000 to $4,999,999 = $137,000 plus 9.65% on the part of income over $2 million.
· $5,000,000 to $24,999,999 = $426,500 plus 10.3% on the income over $5 million.
· $25,000,000 and over = $2,486,500 plus 10.9% on the income over $25 million.
Normal NY income tax rates
In addition to the pass-through entity tax rates above, New York residents and those with New York-derived income from sources other than the pass-through entity must also report such income, which is taxable at rates ranging from 4% to 10.9%.
Bottom line: Weigh all the factors before you elect the New York pass-through entity tax
To determine if you should opt into this tax change, you need to consider your income level, your individual tax bracket, your entity type, and whether it is worth changing your entity selection and itemizing your SALT to take advantage of the potential tax savings at the federal level to offset any increases at the state level. In addition, you need to factor in the varying tax rates for federal and state income tax, the NYS pass-through tax and SALT taxes. There may be additional guidance as the year progresses, so watch for updates about these potential impacts.
Jonathan Medows is a New York City-based CPA who specializes in taxes and business issues for freelancers and self-employed individuals across the country. He provides tax, accounting and business articles for freelancers on his website, http://www.cpaforfreelancers.com, which also features a free newsletter, blog and a comprehensive freelance tax guide.