Recent changes in the federal state and local tax (SALT) deduction are having a ripple effect in New York and several other states, too. 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, which is 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 from this change, 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.
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 off-set credit includes income paid to partners/shareholders, including individuals, trusts and estates at the rates below.
Pass-Through Entity Tax Rates
Income Level | Rate
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 truly 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, too.
Jonathan Medows is a certified public accountant licensed in New York, New Jersey, Maryland, and Pennsylvania. He is also a recognized expert in taxation for freelancers and the self-employed—often tapped for his expert knowledge and perspective on self-employment taxation by national and regional publications such as The New York Post, BusinessWeek, Forbes taxation blog, WebCPA, CPA Practice Advisor, and others. You can read some of Jonathan’s press coverage here.
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