On January 13, 2020, New Jersey (“NJ”) enacted an elective pass-through entity (“PTE”) tax to help mitigate the ramifications of the $10,000 cap on the state and local tax deduction for federal income tax purposes. As originally enacted, the PTE tax had several technical flaws that caused many pass-through entities (e.g., partnerships, LLCs, and S Corporations) to refrain from electing in for tax years 2020 and 2021.
On January 18, 2022, Governor Phil Murphy signed legislation (S-4068/A-6110/6185) into law, which makes a series of changes and clarifications to the PTE tax. The “new” version of the PTE tax is effective beginning for tax periods starting on or after January 1, 2022. The changes and modifications made by the recently enacted legislation include:
- Tax Base Changes and Clarification — The new law provides that partnerships and multi-member LLCs may include in the PTE tax base all income allocated to New Jersey resident partners regardless of source, while still including only New Jersey-source income allocated to nonresident partners. This represents a major benefit for PTEs with resident partners or LLC members since all their income from the electing PTE will be included in the tax base. (Please note that electing PTEs may wish to consider special allocations at the federal income tax level to account for the tax base differences between resident and nonresident partners or members.)
However, for S corporations, the PTE tax base includes only S corporation income allocated to New Jersey (from state sources). Finally, the legislation codifies the Division of Taxation’s (the “Division”) current policy of using the New Jersey Gross Income Tax Business Allocation Schedule (NJ-NR-A) for purposes of determining New Jersey-source income, which relies on a 3-factor apportionment methodology of property, payroll, and sales.
- The PTE Tax Credit — Under the current PTE tax law, a shareholder, partner, or member of an electing entity receives a tax credit based on the amount of PTE tax paid on their share of income. The legislation solves one significant issue related to tiered PTEs (i.e., a PTE owned by another PTE) by permitting the PTE tax credit to be allocated to shareholders of an S corporation, or partners of a partnership when those entities are the partners/members of an electing PTE. The law already provides that when a trust or estate is a member/owner of an electing PTE, the PTE tax credit may be allocated to beneficiaries.
Additionally, S corporations and partnerships/LLCs who own interests in electing PTEs may also choose to apply the PTE tax credit against their own PTE taxes (if they elect into the regime), taxes imposed under the Corporation Business Tax including nonresident withholding, and S corporation minimum taxes and partnership filing fees. Finally, the legislation authorizes the Division to adopt regulations which would permit Gross Income Taxpayers to apply overpayments from PTE tax credits against estimated payments to avoid having to double up on PTE and estimated payments at the individual level on the same income.
- Nonresident withholding — The legislation clarifies that a partnership is permitted to cease nonresident withholding when the nonresident is expected to be refunded the tax due in light of the entity electing into the PTE tax regime and the nonresident receiving the resulting PTE tax credit. Again, this marks a significant change in eliminating one of the perils of electing into the PTE regime by having to pay both PTE and nonresident withholding.
- PTE Tax Overpayments — Electing PTEs are permitted to apply overpayments of the PTE tax (reported on the PTE-100) against the electing PTE’s estimated payments in the following year.
- Rate Change — Finally, the legislation would impose the 10.9% rate on an electing PTE’s distributive proceeds (the PTE tax base) in excess of $1 million.
These changes are set to take effect for tax years beginning on or after January 1, 2022. The decision to elect into the PTE tax regime is one that is filled with several complexities and state tax ramifications which could potentially alter or reduce the overall tax benefits of electing into the regime. Therefore, it is essential to discuss the election and resulting ramifications with your state and local tax advisor.