Year-End Tax Planning Webinars for Funds and GPs | Part III

Just have a little quote here from Steven Jobs, which is really saying, can't just do things the same way we've always done them and can't just look to how it was done last year. Especially now because these things, especially in the pass-through entity tax arena, are just constantly changing. I would say every year, but sometimes several times during the year. So you really need to keep up to date on those and not just say, well, this is the way we did it last year.

And with that, we're going to go to the pass-through entity tax. I'm going to turn it over to Denisse.

Denisse Moderski:Thank you Gary. Hi everyone. Denisse Moderski, a tax director in our Metropark, New Jersey office. So as Gary mentioned, PTET is one of the hottest areas that our team has been busy. Financial services has been a very big area where we see a lot of opportunities with PTET. So just we dive into some of the state tax updates. I would like to go an overview of what is the PTET, just as a refresher. And here's a little background. The PTET came out in 2017 when the Tax Cuts and Jobs Act was enacted. Basically what it did is it created a $10,000 limitation for state and local tax deduction for federal purposes. Now this applied to individual taxpayers. So we can imagine folks that live in high tax jurisdictions such as New York, New Jersey, California, our property tax, our state income tax is well over $10,000. So this was a detrimental impact to those folks in those states.

The first state that came out with a PTET was Connecticut, making it a mandatory election, I'm sorry, a mandatory PTET. And it's an entity level tax. So that was in 2018. And currently, PTET the SALT limitation is effective for tax years 2018 and sunset to 2025. However, there is, the Speaker Johnson vowed to bring a tax bill to include an increase to the SALT limit, but that's still unclear. So we don't know what it's to happen, if this is going to be extended or not. So for now, PTET is here and we assume it's going to be here for a little bit longer.

So there are about 36 states that have a PTET available and New York City. We presume that there might be other states also enacting a PTET as time goes on. I believe there are a few states that have a draft, a proposed bill to enact a PTET, but that has not been passed yet. Pennsylvania is an example.

And how does the PTET work? So as I mentioned, it's a pass-through entity tax. It's an entity level tax, except for Connecticut that it's mandatory. All the other states, the 35 states and New York City, it's an option, it's optional, it's an annual election for the most part. And the way it worked is you have a qualified entity, whether it's a pass-through entity or an LLC treated as a partnership or an S-corporation, they can make this election and be taxed at the entity level.

And the way it works is it's a federal benefit in the sense that you have the tax deduction taken for federal purposes at the entity level which flows through the individual taxpayers through their K-1. So prior to PTET, the way it works is you have your taxable income, your federal taxable income flows to the individuals, and then the taxes paid at their level. By having this PTET, you are reducing that federal taxable income that's flowing to those individuals, and they get to get a benefit that way. The entity is not limited to the $10,000, so cap limitation. So that it's a bonus. And as I mentioned, it's an owner's distribution that they get this credit. And that's at the federal level.

Now many states also provide a state tax credit to the resident state for this PTET. For example, New York State, if you have an entity that it's making a PTET election for New York state purposes, you're getting the federal benefit, the deduction through your K-1, presumably let's say line one, your ordinary income is getting that deduction. Then the individual, when they file their personal income tax return with New York State, they also get a credit for that New York PTET. So you're getting not only a federal benefit, but you're also getting a state tax credit. And another benefit is that generally you have individuals that are required to make quarterly estimates right under income. By having this PTET election, the entities taking that responsibility, and individuals do not need to make an estimate separately for that income. And that's provided obviously this is the only source of income comments through. So that's a really big bonus, right? You have an entity taking care of the obligation for your individuals, your investors. So that's one.

We do have a polling question now, so I will give everyone, I believe we have a minute, right, Bella, for polling?

Bella Brickle: Polling Question #2

Gary Bingel:  And a couple of things, while everybody's doing this answer here, a couple of things to think about. One of the reasons why the PTETs and pass-through entity run taxes have been so complicated is that each state, like everything in state tax, each state is a little bit different. Each state has its own nuances as to when you need to elect, how you elect. There are also differences in how the whole regime works. Some states do give you a credit for taxes paid essentially at the individual level. Other states they don't flow through the income to the individual or the individual gets a deduction for the amount of income that was paid by the pass rent tax. So there were a lot of different nuances.

And along those lines when I'll say these PTETs were blessed, so to speak by, the IRS back in 2020, they were supposed to come out with some additional guidance on them, which they have yet to do. But I did just see yesterday or the day before that the IRS has come out and said they know that the PTET will probably extend beyond the current sunset date. And so they do know that they do need to issue new guidance and they're going to be working on that probably just in time for it to sunset, but they are working on some additional guidance. So we'll see what they eventually end up coming out with and how that may impact things.

Bella Brickle: Perfect. Well I have gone to the results. So back to you.

Denisse, are you there? All right, well apologies for the technical difficulties.

Nicholas Montorio: I can take this one. So this slide talks about California's pass-through entity tax changes. So the PTET election, by the original due date or the extended due date of October 15th, there are mandatory payments that has to be made either during the year or at the time of payment. Let's see. Oh, Denisse back. Sorry, go ahead. There's your slide.

Denisse Moderski: Yeah, I'm sorry about that. My VPN dropped. You want me to take on?

Nicholas Montorio: Oh yeah, sure. I'll finish the chart at the top. So one of the things we've seen that's super important to making the election and to California Franchise Tax Board is form 3804, must be attached to the actual filing, and that's the form that's used to show how much the California PTET is, and more importantly perhaps how much credit each individual partner or shareholder will receive of that credit.

Denisse Moderski: Yeah, and to add to that, I also thank you Nick. The form 3804, again, it's not a annual return per se, it is a schedule that breaks out your allocation of your PTET taxable income and credit. That is an attachment that has to go with a tax return when you're filing, whether it's by the due date or the extended due date, but that's something that always has to be attached to your S-corporation return or your pass-through entity. There is another form form 3804 CR, and that's the schedule that the investors getting the credit would attach to their individual tax return. So we are highlighting here form 3804 only because that's the actual form that goes with the entity's tax return. And one thing we want to obviously make it clear is that because the guidance on the FAQs does not say the proper steps to make the PTET election other than the payment. We do know from communications with the state that this form needs to be attached to the return. So that's one thing to keep in mind.

Other things I think, Nick you mentioned about the tax base, have you? Or I can go into the second part. Okay, so for California, the tax base, they do have this concept of resident versus non-resident pool for your eligible investors. And what is an eligible investor? We're looking at your individuals, trust, states, granter trust. So those are the qualified members that would be getting a PTET credit. And the way it works is you break it out between all your resident members and your non-resident members. Under resident members. The PTET is computed on all of their income versus your non-resident, which is only based on California source income. So once you compute the two components, you aggregate that and apply the 9.3%, which is the PTET tax rate for California. And that's the PTET liability that gets reported on the form 3804, which breaks it up by partner. And it also goes obviously on the tax return of the entity and you must match the payment that was made.

The credit, it's a non-refundable credit on individual level. So presumably if you have an investor that is in the loss or may have no LSS. And they have a PTET credit flowing through, to the extent they cannot utilize the PTET that it's a non-refundable credit, but it gets carried forward for five years. If they don't use it in the five-year period, then you basically lose it. Other things is by making a PTET election, the entity still required to compute non-resident withholding. California has a non-resident withholding requirements for pass-through entities and S-corporations, believe it's a 7% tax rate for domestic investors.

So if you have an entity that is looking to make a California PTET election and they don't want to make the two payments for withholding and PTET. One way to do this, and this is important for year-end planning, part of this discussion, is you may want to consider doing a waiver, a non-resident withholding waiver, which is Form 588. There is another Form 590, but that's applicable only to specific entities. So by filing this waiver, the Form 588, you send that to the state, California is one of the states that requires state approval before you can accept an entity from non-resident withholding. So you have this waiver. Once the state approves it, then you do not have to make a non-resident withholding, you can just make the PTET, make the payment for the investors and distribute that credit to them.

It is important though, with non-resident withholding, to remember that there are due dates when this must be filed. And again, because it requires state approval, this is probably the time that if you are planning to do a PTET election for 2023, 2024, you may want to consider having this waiver in place and file with FTB. The waiver is good for 24 months. So if you do one for '23, you should be covered through 2024. To the extent the waiver is denied, this entity is still required to make a non-resident withholding payment.

We are going to cover California Legal Ruling 2022-01 on our later sections, but I just want to note that based on this ruling, there are some implications of in sourcing in terms of sourcing for computation of service providers, a management company for example. So keep in mind that once we go through this section in more detail is this can impact the way we compute the California sourcing income, which essentially impacts the PTET, the PTET base for those non-resident members. And we'll cover that in another section, but I just wanted to highlight that.

Other things to keep in mind is this was a change effective for 2022, the credit ordering rule starting in 2022 and forward, the state tax credit that it's apply is any taxes for example, a non-resident withholding tax that you pay to other states, that gets applied first at the individual level before any PTET. So from planning purposes, think about an investor who has investments in many private equity funds or investment partnerships and they're getting all this withholding credit. Those credits will be applied first at their level before any PTET. So it could be that you may end up in a position that you have so many credits for taxes paid to other states, that you won't be able to utilize the PTET. So that gets carried forward. It's a non-refundable credit, so it gets carried forward for five years. So this is something where we may want to consider if we have substantial PTET credit, do we want to do waivers so that we can accept that of withholding and that way we can utilize the PTET. Just something to be mindful of.

Other updates, California provided guidance is that if you have an entity that was created after June 15, those entities are still able to make a PTET election. And the June 15 if, I don't know Nick if you mentioned this on the prior slide, but in order to make an election for California PTET, there has to be a prepayment made by June 15 of a greater of 50% of your prior year liability if you made an election in the prior year for California PTET or $1,000 minimum. So as long as that it's paid by June 15, then you can make an election. You will be considered qualified.

If you do not meet a prepayment. California is very strict where it says that if the payment is not made by June 15, the entity PTET election will be invalidated. So something to be obviously aware of as we are planning this right for next year, if we're making an election for the following year, June 15, there is a prepayment requirement.

But again, that rule does not apply for any entities that are formed after June 15th. So if you have an entity that's formed let's say August 15th, they may still make a PTET election. They will have to make a payment by the original due date of the return, which is March 15th, or if it's a cash basis taxpayer, you want to make the payment by December so you can get the federal deduction in the year paid.

Another point here, special transactions for tax years 2022 through 2025, I know before we mentioned the 50% or $1,000 minimum repayment. One question that always comes up and especially financial services is when you have a special transaction, let's say you have a sale of a partnership interest in year one, and you made an election for PTET. Now year two, you do not expect to have the same transaction, but in order to make a PTET election in 2022, you have to meet a 50% of your prior liability. But prior liability, you have a significant gain from that sale. Is it fair that now I have to basically pay that minimum amount in year two by June 15 in order to qualify? Unfortunately, that is the rule with California. Even if you had a one-off transaction in year one and you made a PTET election, in order to make a year two election, you have to make that payment a 50%. So again, something to keep in mind as we're planning for the year.

Now I'm going to talk about some Connecticut tax changes. Connecticut I mentioned earlier is the first state that came out with a mandatory PTET in 2018. Now those rules have changed. There was a bill that was passed that it changed the mandatory PTET to now become elective starting tax year 2024. So it's no longer a mandatory, it's an optional. You can make an election starting in 2024 if it makes sense to make a PTET election or not. Other changes that went into place with this bill is that prior to the bill, entities that were commonly owned, like an 80% ownership, if you have a brother sister entities, there was an election where you can do a combined entity filing, meaning that you will file a Connecticut tax return for separate or your brother sister entity separately.

But for PTET purposes, you can make a combined election where you can aggregate all of the income and pay the tax at the parent level, for example. So you don't make it at various levels. That went away. That's no longer available. It's starting in 2024.

The tax base is another big change. Current law right now, you have two options of how to compute your PTET for Connecticut purposes. You can do it based on the standard base, which is the default method, and that's based on your Connecticut source income for all your members. The other option is your alternative base, which is basically your modified Connecticut source income plus unsourced income. And we don't really see this alternative based method as common as the standard. And for example, I'm going to mention it, if you have a GP entity or a hedge fund where all they have is just portfolio income, for example, and there is no operating activity, you may have income there that is unsourced, that is deemed unsourced income and Connecticut residents. That's where it makes sense to make an alternative base method. Because you maximize the benefit for those Connecticut residents. You're not just pulling any Connecticut source, but you're pulling any sourced income that flows to those direct members.

Now starting in 2024, the standard base method, which is the Connecticut source, it's gone. Now the only way to calculate PTET is based on alternative base, which again, it's your modified Connecticut source income plus any unsourced income. The tax rate remains same 6.99. The credit limitation is also the same, 87.5, there was a draft proposed due to raise it up to 93.01, which was the original limitation in year one, but that did not go through. So it's still 87.5.

Owner filing requirements. So these are for your individual members, your non-resident, Connecticut non-resident members. There was an exemption to have to file a separate return at individual level provided that enough tax was covered by the PTET. Now starting 2024, Connecticut became, they basically reenacted their mandatory composite filing requirement. Prior to PTET, Connecticut used to be a mandatory composite tax state. So basically what you did is you computed tax on all your non-resident members and now that's back into place starting 2024. So something to be mindful is it is a mandatory composite. It is not optional and it's only included on your non-resident, non-corporate members.

I talk about the alternative base here is down sourced income. One change also from the prior bill to the current. In order to determine on source income is any income that is not sourced to any state in which the pass-through entity has nexus. And that directly flows to members who are resident individuals. Now, in order to make the determination that it's not sourced to any states. Prior to the bill, you had to apply the Connecticut sourcing rules to determine that. So Connecticut has a $500,000 threshold, economic nexus threshold, to compute nexus. So with the change now, you do not have to follow Connecticut sourcing and apportionment rules to determine the unsourced income. Which is beneficial because let's say you have income that is unsourced to a state where you are below the 500 or over the 500, you don't have to apply Connecticut laws to determine that. So that's something too, which was helpful.

Modified Connecticut source income, so these two components is what makes up your alternative base, which is your taxable income for PTET purposes. Modified Connecticut source income is basically the portion of Connecticut source income minus any Connecticut source income from lower tier. And this makes sense, right? So if you think about it from a tier structure, you have the operating entity, the management companies, they're making their PTET elections, they're making the payment, they're going to flow that credit to their upper tiers. The upper tiers presumably have no other activities in Connecticut other than this pass-through income. They're not going to be taxed on the same income twice. So that's what this means. It's like you take your operating activities minus your flow through investments, and that's your modified Connecticut source income.

So in a tier structure what we often see is most entities file, they use the standard method because once you compute your modify Connecticut source income, you're not computing tax at every level, it's only really happening at the entity level, at the fund level.

Another change with 2024 is that corporate members are not longer included in PTET. So they got rid of the corporate members credit for PTET. So that's obviously something that if you have a tier structure and to the extent there's a corporate blocker or corporate partner that it's in Connecticut, they are going to be getting Connecticut source income, and there won't be a tax associated flowing through. So that is a separate tax that would need to be paid at a corporate partners level. And those are the big changes with Connecticut. Going to pass it on to Nick now to go over New Jersey. Thank you.

Nicholas Montorio: Great. Thanks so much Denisse. So New Jersey had major tax reform yet again, I think probably for the third time in the past maybe three years. So this time, the rules are that with respect to partnerships in general, which will obviously impact general partnership filings as well as the PTET filings for partnerships. So the first major change is the apportionment formula. Historically, prior to 2023, the partnership would use an evenly weighted three factor apportionment formula consisting of property, payroll and a sales factor. Now starting in 2023, it's just a sales factor which is consistent with the corporate rules, which have been around for a few years now. The other change also to be consistent with the corporate rules is to change the methodology used to source sales, particularly services, which were historically sourced to the office of origination/the cost of performance or where the payroll and costs incurred. Now, market-based sourcing for partnerships.

And the main point here is historically there was a material disconnect between the non-resident withholding rules for partnerships, which relied on corporate sourcing and corporate apportionment rules, versus how the partnership actually computed its tax return. You could have widely different tax liabilities depending on which methodology you used and it always created headaches. I know I got some myself. These rules take those headaches away and now the partnership and the corporation will use the same rules. Some additional points to think about. So the actual statute for the sourcing rules says that the partnership can use different methodology if the information is readily or accurately ascertainable. We've had some discussions with the state and the state says basically to ignore that statutory language, they really want you to use market-based sourcing. But you can't just ignore a statute because the tax department tells you to. And I say that to say there could be a position to not follow the corporate sourcing rules if you do have certain data and certain facts and circumstances that would support another methodology.

Specific to asset management companies. They are required to the look through approach for certain customers when the customer is an investment fund, for example. So you wouldn't use say the fund's billing address, you would've to look through to the investors of the funds, which you may not even have access to. But that is the role for the corporations. And that same role would apply now to partnerships. Interest in penalty relief, so this change happened during the 2023 tax year after the estimated payments have been made using the old rules. Now with this law change, there obviously could be an impact to the tax liability actually due. The state has been fairly kind in terms of waiving penalties and interests associated with this law change during the tax year.

And finally, the question is always, well, how do I know whether the partnership should file with New Jersey? New Jersey is one of those states that has a very broad "doing business" standard for tax filers, or if you have any income source to the state you're supposed to file. That's obviously on the conservative side. There is a rule for corporations. And this rule only applies to corporations and it says, if you have $100,000 or more of sales source to the state, then you have economic nexus. You've crossed that threshold. To be crystal clear, that the rule does not apply to partnerships. But as a practical approach, one could use that 100,000 threshold as a guiding post for making your filing determinations.

Here's some changes for New York State and New York City. So the tax base now includes the pass-through any taxes paid to other jurisdictions, which is actually a good thing. You want that tax base to be higher, that increases the federal deduction. For New York City taxpayers, estates and trust are now eligible to make the election. Reorganizations, this comes up pretty often where you have an entity that made a PTET election and there was some ownership change, some transaction. The question remains, does that PTET election survive the transaction? And the state has issued some guidance on this point saying that the election will remain as long as these three requirements are satisfied. That being that the successor entity continues, is a continuation of the original entity, the original entity did not file a final return, and that the successor entity reports all of the income from both before and after the transaction.

Late elections. I chuckle here because I can't tell you how many times someone has asked if they can make the election after the March 15th statutory deadline. They cannot. That March 15th deadline is solid. No matter what. Even if you were formed, it came into existence after that deadline, basically too bad you can't make the election for that tax year.

This is a taxpayer friendly rule, although it has some administrative complications. So if you have an overpayment for New York state, an underpayment for New York City, one, the overpayment part can be applied to the New York City underpayment part, for example. But I think it's just hard administratively to keep track of this unless the state gives you, I guess information right away that they've actually done this on your behalf. So I don't know, Denisse. Denisse, have you come across this before?

Denisse Moderski: Yeah, so before we go into that, I do want to make one comment on the late elections because this is very important and I think obviously with asset management we have a lot of companies, New York-based, so New York that is a very common election that we've seen. One thing I always recommend, especially at the GPs, if you don't have certainty of to why your income will look like, for example, for the GP entities that have, I guess carry and don't have visibility when the fee will be crystallized, I always say it's always good to make the election because the last thing you want is let's say receive your income, your fee crystallizes at year-end. And it's significant. You cannot go back, excuse me, to retroactively apply a late election. So that could be a detrimental impact to those investors, to those residents in New York, for example. So always something to consider.

The worst case that can happen is that you make an election. Let's say you end up in a loss or no income, you just file a blank return, zero return, no harm, no foul. Or if you made payments and you end up on a loss, you get the money refunded. But what if you happen to have a significant transaction, or like I said, the incentive it's crystallized, then you're stuck. And you have this income, then what does the GP do? They cannot go back and make that election. So always discuss with your advisors, your tax advisor, but it's something always to be mindful of because of this March 15 due date on late elections.

Yeah, sorry Nick, I just want to make sure I would mention that because that's been a big one in asset management.

In terms of the New York State, New York City overpayments, you mentioned it's a tax-friendly, which is great because again, we have taxpayers where income can fluctuate. So to the extent you may have additional payment in New York City, you can carry any of the new state to New York City or vice versa. Unfortunately, any overpayment passed, once you apply to New York State, New York City PTET, you cannot carry forward. That has to be refunded back to the entity. And there are no options to do a direct deposit or anything. It's all paper check. And that's just the way the state guidance is and I don't know if it's going to change or not. But for now, there is no way to carry forward any overpayments. Yep.

Nicholas Montorio: Oh, and here we have a polling question. Bella, do you want to handle this?

Bella Brickle: Polling Question #3.

Gary Bingel:  As everyone can see with a lot of these things, there's a lot of just constant changes. And unfortunately, even the regs, they're not going to address every situation. Everybody has, especially when it comes to things like reorgs, I would say that's probably one of the biggest, most frequent questions we get, that Denisse and Nick and I get about how to handle PTET payments or whatnot when there are mergers and acquisitions of some sort. So that's something, if you've got something like that coming up, you're going to want to try and get ahead of as much as possible, I think.

Bella Brickle: Great. I'm now going to close this poll and share the results. After you Nick.

Denisse Moderski: Yes. And to add into the reorg stuff, there is also some, because again, you're talking from one change of an EIN, from one end to another. We have seen a lot of notices associated with that when investors try to claim their PTET. So it's definitely important to make sure that we are reporting this properly because if it's not correctly disclosed on your K-1 or how it's picked up by the individuals, you may get a notice disallowing that credit. So yeah.

Okay, I think this is our next section. So we talk about the PTET major updates for obviously there are more states with PTET, there's so many rules across the board, but we wanted to highlight the most important ones. New York State, New Jersey, California, and Connecticut. Now we're going to talk about state sourcing and changes, any updates for year-end planning. So California is one of them. They released a Legal Ruling 2022-01 back in 2022. And according to the legal ruling, this would apply effective for tax years 2023. And this is talking about service receipts, right? So we're thinking about financial services, let's talk about the management companies. When we're talking about management companies, like how do you source those management fees for California purposes? And the general rule is, you source it to where the customer receives the benefit.

But this is always a great area because when you're talking about management companies, management companies are getting fees from funds, but funds really considered the benefit? Who is really the ultimate benefit? That is always the question. Well, what is California's intent? Do we stop at the fund or do we look through those investors that essentially are getting the benefit, right? And this legal ruling provided very good examples, specifically I guess to service companies. What it does is basically looking at your ultimate beneficiary. Where is that location? Where is that? So in context of financial services, we are really looking to all those investors, those California investors of the fund, the pace, the fee to the management company. So it's an indirect look through approach. There is a look through approach. California does have an economic nexus threshold. I believe it's around 637,000. So to the extent you reach that, there will be some filing requirements. There will be some nexus in California.

And we may have, think about companies that have offshore accounts, if you have offshore accounts, those are foreign accounts, but there could be some California custodians. So that could create some potential sourcing, some potential nexus in California. So things to think about as we're dealing with ERM planning, looking through who is really the customer, who is the ultimate customer?

Obviously there are other regulatory guidance in terms of where the services received. Here we're talking about real property, tangible personal property and tangible property individuals. That's a little bit more clear to trace when you're dealing with tangible property or real property because you can easily trace it. But when you are dealing with services, it's not as clear cut to where is the benefit received?

I mentioned here the four key questions. Again, in financial services context, think about who is the customer. It's the fund, really the customer who's paying the fee? Are the members of the fund the customer? Who's getting the benefit? In our management company scenario, would really be considered your investors, those California investors, getting where the fund is pulling capital. And then they're basically the investors are getting all the profit and share, they're getting the ultimate benefit. So that will be considered a look through approach. That's what would dictate your California sourcing.

Here are some examples from the legal ruling, I'm not going to go through each one, but I'm going to highlight example number three. Here's an example of a consultant, right? It's an engaged as a subcontractor and sources sales related to a manufacturing plant to where the plant is located, not where the primary contractor is located. Again, depends on what services we're talking about. In asset management, we are really dealing with tangible services. It's more intangible. So where is that service going to? Who is getting that service?

And now I'm going to pass it on to you, Nick, for New Jersey.

Nicholas Montorio: Great, thank you. Yeah, so as I mentioned before, New Jersey has done a lot of corporate tax reform over the past couple of years. The most recent one established that $100,000 economic nexus threshold for corporations. I know this doesn't apply to financial services, but it's worth noting that the state expanded its understanding or definition of what nexus creating activity is in the context of Public Law 86-272, which is companies that sell tangible personal property. And just to state it briefly, almost any company that has a website is at risk of exceeding Public Law 86-272 protections, which prohibits states from opposing a net income tax on corporations that just sell tangible personal property into the state.

There are some changes to combined reporting. So historically, captive REITs, New Jersey investment companies and REITs were excluded from the New Jersey combined return. Now they are included if they're considered captive, which is more than 50% owned.

There's a shift from Finnegan method to the Joyce method, which again applies in the context of a combined return where if one entity can claim Public Law 86-272 protection, and I should say if one entity cannot, then none of the entities can claim public law protection and all entities will be brought into the combined return. For the taxable base, there were some pretty significant changes or clarifications. One for foreign taxpayers, tax treaty benefits will generally apply except for when there is a worldwide group filing election, which is an election available to taxpayers that want to report all of their worldwide income to New Jersey. There are now state specific rules with respect to IRC 174. These deductions are available in New Jersey as long as the expenses relate to qualified research expenditures occurring in New Jersey. And there's some debate as to whether that limitation is statutorily supported or not. That's to be determined. We know the tax department thinks that it is, but there's some, I guess, uncertainty on the tax practitioner side.

The state now conforms with the federal 163(j) rules regarding interest limitation deductions. This last point, very taxpayer-friendly. NOLs that were in existence prior to 2019, which is the first year of the first set of corporate tax reform, can now be shared in the combined group setting. Historically, those were treated as surly limitations where only if the entity generated income could it use those historical NOLs to offset its own income.

Some significant changes with respect to dividends. GILTI is now considered a dividend, which is obviously very important for many reasons, but one being that the dividend received deduction can be claimed with respect to GILTI. The DRD can be as much as 100%. However, there's an automatic 5% claw-back. It's a way that the state is just attributing direct and indirect expenses to this dividend income somewhat of an arbitrary number, but it's a set number that everyone just knows there's not going to be any debate about that amount. So there's going to be a 5% haircut on dividends.

And finally, this last point, very taxpayer-friendly. The dividend received deduction can now be claimed before NOLs. Historically, you have to use NOLs to offset effectively tax-exempt income or DRD income based on the ordering of how the deductions were claimed. But now the DRD can be utilized and claimed prior to using net operating losses.

Gary Bingel: Yeah, and one thing I want to point out on New Jersey real quick, over the last three, four months, New Jersey has come out with just tons and tons of additional guidance, all of which is posted on their website, everything from combined reporting to nexus. So to the extent people have a lot of questions on some of these New Jersey changes, there's a good chance if you check their website that they've got a new technical bulletin of some sort that they would've just released in the last three, four, five months on it. So I would advise a lot of people to look there on a lot of these because a lot of them get into a lot of very specific detail on who is included in a combined report, how to handle Joyce v. Finnigan, and all those sorts of things. So the websites are getting better and better for some of these states as far as issuing guidance.

Nicholas Montorio: Yeah, absolutely. Okay. So New York corporate tax reform updates. So as everyone probably knows, New York had major corporate tax reform starting in tax years, 2015. The state has been issuing draft proposed regulations for years. Now at this point, we think we're at almost the finish line for these draft regulations, which just some eight tax years after the tax law was modified or reform. Some of the major rules to point out for this audience would be the rules with respect to passive investment companies, which is head funds or any company that pools the capital of investors and investment companies or REITs. So for those service providers, those companies that provide services to these types of companies or customers, you are actually required to look through your customer to the ultimate investor in that company. And source income or sales to New York based upon the ratio of New York investors over total investors.

Sales of partnership interest in stock. So the statute says in general you would exclude these types of sales from your sales factor. However, based on the proposed regulations, there's a good chance and there are many circumstances in which you would actually include sales or partnership interest and stock in your sales factor. And that's something we're going to talk about in the next section. Some of those specific rules.

The most recent New York fiscal budget had a number of changes, but the main one to point out here would be with respect to the MCTMT, which is a payroll tax that applies to employers in the New York City and Westchester areas. So historically, limited partners were not subject to this tax, but New York State would audit limited partners and try to apply this tax to limited partners who are active in the operations of the fund or lower tier partnership.

And there was a lot of back and forth. There was not clear guidance, a lot of litigation, a lot of settlement negotiation, so on and so forth. This fiscal budget clarifies what the rule will be going forward. Now the statute says if the limited partner is actively engaged in the operations of the partnerships activity, then it will be subject to this tax regardless of his title as a "limited partner". So in other words, the state will be looking to the substance of what the partner's activities are in the fund as opposed to just their mere title. There's a New York State publication Publication 420, which is some 25, 30 pages long that only addresses this very specific type of tax. Unfortunately, it has not been updated yet to explain when an individual will be considered active.

One of the things that out the state might take would be to make that distinction that we see in the passive activity loss rules. Maybe something like if the partners engaged in operations more than 500 hours per year or any other of the number criteria that are used to distinguish between passive versus active partner. That could be the route that the state takes, but that's just speculation at this point. And there's also a rate increase for those employers who have New York City operations. So historically it's 0.34%, now it's been increased to 0.6%.

Audit activity. New York City UBT, the audits never stop. The two main issues we see time and time again would be payment to partner add back. There's all sorts of different fact patterns and structures and scenarios where the city is looking for add-back to the taxable base for any payments that are made to a partner, direct or indirect. And the other main issue that's also related in some cases, would be the sales factor computation. The state, should say the city, does not have particularly good guidance on how to source sales under more complicated fact patterns. So usually a case by case basis facts and circumstances will dictate what the taxpayer sourcing rules and sourcing methodology should be.

The other main audit activity we've seen in New York State would be personal income tax credits for taxes paid to other states. This is different than the PTET section we talked about. And the idea here is that New York state has very specific rules for sourcing sales of services, more of a cost of performance or office of origination methodology. And other states, say California, use a market-based sourcing methodology. So if taxes were paid to California using market-based sourcing, the state of New York might say, well, what would your tax liability to California be if you use or when you use New York's rules, cost performance type rules. And to the extent there's a disconnect there, there could be an issue with a credit claim by the New York resident individual.

Massachusetts is next. Denisse.

Denisse Moderski: Yeah, and especially that's actually important with the tax credit, because now we see New Jersey changing in 2023 for partnerships. It's now going to a market-based sourcing, that obviously there is some exposure there in terms of the credit being limited for New York residents that you're paying taxes now to other states based on different, if you apply that New York rules.

Okay, so one, I'm going to go over this quickly so we can make sure that we cover the next sections, but our Massachusetts another state, they recently passed a bill to change their apportionment factor, apportionment formula for corporations. And since partnerships also follow corporate rules, it would apply to partnerships as well. And this change is effective 2025.

And currently, Massachusetts, the way you apportion your income is based on a three factor apportionment, double weighted sales. You take your payroll property and sales, sales being sourced on a market based sourcing approach. So now with this change, switching into a single sales formula, that's a change that's going to impact your corporations, your partnerships, and also your Massachusetts PTET.

Other changes were to financial institutions. So prior to 2025, the way we currently source income from investment and trading activities to the state is if the regular place of business is taking place in Massachusetts, for example, the customers commercial, in Massachusetts, like a regular place where the business are conducted, that will be considered Massachusetts income for financial institutions.

Starting in 2025, the way you source your receipts from any investment or trade activities, you apply a fraction that is based on the amount of activities, whether it's lending, credit card leasing activities that take place in the state. Other major changes were related to the personal income tax. Short-term capital gains, tax rates, currently 12% that has been decreased to 8.5, effective 2023. So that is a very good change. Others is that there is now a joint Massachusetts return requirement for married couples if they file married filing jointly for federal purposes. And that's effective 2024.

One thing I do want to say is Massachusetts has a tax on individuals that have more than $1 million of income. There's a 4% additional tax. So the PTET is based on a 5% tax rate. There hasn't been any changes to the PTET, even though there has been some discussions in the state, whether maybe increase the tax rate for PTET purposes to account for the extra 4% for taxpayers that are in over the one million income threshold. So that has not been passed yet. So there should for members or entities that are making a PTET election in Massachusetts, and to the extent the individuals are subject to the extra 4%, they should be making quarterly estimates separately to account for that, as their credit would only be coming in out of 5% tax rate. And there's also a credit limitation of 90%. So similar to Connecticut, Massachusetts does not give 100% of the credit to the individuals, to the members, it's only 90% and it's at a much lower rate than those that are going to be subject to the additional 4% tax rate. So for any quarterly estimates that we are making, individuals should be making the separate quarterly estimate for the additional tax.

And now we have a polling question.

Bella Brickle: Polling Question #4

As a reminder, in order to qualify for your CPE certificate, you'll need to remain logged in for 50 minutes and respond to three out of the five polling questions. Once again, we'll give everyone about 30 more seconds to submit their response to this question.

Gary Bingel: We've had a couple questions about New Jersey's new $100,000 nexus threshold, and I just wanted to clarify a couple of things. One, that $100,000 is in addition to any other nexus creating activities you may have. Or maybe not an addition, the requirement does not supplant those, its supplements. And so all the other physical presence, et cetera, all those nexus creating activities but still create nexus, even if you had below $100,000 of New Jersey receipts. That was really just to put the corporation income tax nexus provisions in line with the sales tax provisions.

New Jersey has not come out and explicitly stated, I don't believe whether though that $100,000 economic nexus provision will apply to partnerships and sole proprietors and such. But to be honest, I don't see why it wouldn't. New Jersey's going to be looking to impose tax as it always has as much as it can. And that constitutional provision, if you will, the Constitution basically applies the same for all taxes, all entities and such. So I would expect that there's, I think as Nick said, at least a position at that $100,000 would apply to all types of entities, just like all the nexus provisions presumably would apply to all types of entities.

Bella Brickle: Great. So these are the results to the poll, and with that I pass it back to you all.

Nicholas Montorio: Thank you. Now we'll be talking about sales of partnership interest and S-corporations. So before we get into any specifics, and we'll focus on New York for the most part, there are some general topics that really take a long time to address, but for the time that we have, we'll do this pretty quickly. So the first idea is whether or not the sale will actually be apportionable to all the states in which the selling taxpayer has nexus or if you can allocate it to a particular state, basically a business versus non-business type of analysis.

Assuming it's in the taxable base, the next question is whether or not the net gain or even the gross sale will be in the sales factor. I'd say the majority of states probably would say to exclude it, and the states that would require inclusion of the sale and the sales factor really vary all over the place. Some states say source it to commercial domicile of the seller, commercial domicile of the buyer, where the decision was made to make the sale, so on and so forth. So the rules really vary there on the sales factor analysis.

And tiered structures, we have say an upper tier partnership selling a lower tier partnership. There's the constant question of whether or not you're supposed to flow up the factors of the lower tier partnership to the upper tier partnership. And the answer to that question could materially impact the tax liability reported by the selling upper tier partnership.

As we'll see in the next couple of slides, there are different rules for different sellers. So anytime you start thinking about how you're supposed to report the sale of a partnership interest or the sale of an S-corp stock. You have to think who is actually the person or individual or entity selling this because the rule could change drastically depending on who the seller is.

Just to come full circle to the PTET conversation we had early in this presentation. Again, as we mentioned before, if there is a transaction, does that impact the PTET election for the electing partnership with the electing S-corp? And then what impact does the PTET calc have or PTET liability have on a gross up calculation if it's an S-corp? And what we've seen is, so historically the sale of S-corp stock, for instance, under these new rules with the $10,000 limit, the selling shareholder would not be able to deduct more than $10,000 of state taxes paid.

Now if you go to the H10 transaction where it's a deemed asset sale and that gain is included in the S-corp, in the entity, now the entity can deduct any state taxes paid, which actually is a favorable answer for the selling shareholders. And that could have a material impact on what the gross sub calculation is between the stock sale and the asset sale.

So with a New York spotlight, who is the seller? In the context of a C-corporation, generally all income will be included in the taxable base unless such income is protected from taxation by the US institution. A fairly high standard to me, but it is mutable. When you get to apportionment and sales factor, as I mentioned before, the statute says you would generally exclude the sale from your sales factor, but the proposed regulations provide discretionary adjustments where the sale often will be treated as if the corporate partner sold its pro rata share of each of the partnership's assets, and source the sale accordingly based on as if it actually sold one of those assets.

Goodwill is typically the largest asset recipient of the purchase price allocation. And when the corporation sells a partnership interest, for instance, you would use the partnerships last three years, business apportionment, percentage to source the goodwill associated with that sale.

Separate accounting election. This is probably the most favorable taxpayer provision in all of New York tax law, which is to say a corporate partner can elect under certain circumstances, to report only its distributive share of income from the lower tier partnership. And exclude any of the gain resulting from the sale or the partnership interest. Now certain requirements have to be satisfied under the proposed regs. I'll give you the updated rules now. So the limited partner, the selling corp, must be either actually a limited partner or a partner in an LLC acting as if it was a limited partnership. That corporate partner has to have nexus with New York solely because of its interest in the partnership. And there must be a non-unitary business relationship between the corporate partner and the partnership.

Prior rules, meaning 2015 and prior, or I should say even prior to the proposed regulations, which are still in proposed form, the separate account election was much broader and much easier to meet. But now these proposed regulations make it much narrower. So who is the seller if you have an S-corp seller? Two things we wanted to point out was the investment ratio test.

So New York is one of the few remaining states where you can be a federal S-corp, but a New York C-corp and there are pros and cons of proceeding in that way. But if you are a New York C-corp under these circumstances and you sell an interest in a partnership or have other disposition that's material, you could be mandated to file as a New York S-corporation as if you made the S-Corp election for New York. And the big case there is the page which came out a few years ago, basically indicating that under many circumstances a federal S-corp that's a New York C-corp, will be mandated to be a New York S-Corp in this type of scenario.

The other thing we wanted to point out was a statutory rule in New York Tax Law 632(a)(2), which says that when there is an H10 transaction and the S-corp receives a note and then distributes that note to shareholders, the shareholders will have New York source income using the apportion percentage of the S-corp in the year of the sale.

Denisse, do you want to handle the partnerships?

Denisse Moderski: Sure. I think we only have a few minutes left, so I will try to cover this quickly. So now going into who is the seller? Let's think about partnerships. What if you have a partnership selling an investment partnership interest? There are no really clear guidance in terms of at a partnership level, not so clear as where you have at a corporation level where you treat as an entity method, aggregate basis. So for partnerships and more into financial services context where you have a tier structure, a lot of these structures are you have a holding company, the portfolio company, holding company sells their interest in a portfolio company. One of the questions, the key questions it always comes down to is how do you report that gain? Is that gain that happens at the holding company level, does that get sourced to New York State, New York City? And how if it does get sourced to New York State, New York City, how do you calculate it? What is the method to do so?

What we typically see is for New York State, it depends if it's a unitary structure, meaning there's any control between the upper tier and the lower tier. Generally speaking, we are dealing with various investments, various portfolio companies. More often than not, unlimited investment, no control, not much management activity between the two. It's just investments in various portfolio companies. So what we see is that the gain gets distributed up to the investors for New York state purposes. And at the individual level, any gain for residents would be picked up under other their level. For New York City, UBT though there are some partial exemptions, there are limitations, there's a gross test whether this is considered sourced to New York City and if it is sourced, do you compute this tax based on the lower tiers apportionment? Is it at the upper tiers? Think about like tier structures. They don't really have any activities at their level. It's mostly common from investments in other entities.

So how do you really determine if you use the entity method of reporting, how do you use their upper tiers, apportionment factors? There is none. So the typical approach, what we see typically see and look at is well, what is the underlying apportionment factors, and do we use that as an estimate, a reasonable approach to calculate the gain that is sourced in New York City? And that's also, if it's deemed to be sourced in New York City, there are some exemptions and some partial exemptions, but again, there are no clear guidance. So this is a very complex area that our team usually sees, especially in financial services. Who is the selling partner? Is it at the holding company? Is it a corporate partners? Is it an individual selling directly and whatnot?

For individuals, I mentioned, only the resident state generally taxes the gain from the sale, but there could be states that also tax this gain to non-residents. New York state specifically, there is a rule that if you have a sale of a partnership interest, and there is an IRC 1060 asset involved, that would be considered source to New York state.

Okay. I think I'll pass it out to you, Nick, to cover the last section.

Nicholas Montorio:  Okay, great. Yeah, we'll move very quickly. I know we're just about out of time. Yeah, so just real quick, many states have two different tests to figure out whether or not you are a tax resident is at the individual level. You could be a domiciliary, which is to say that home is where the heart is, not really an objective test necessarily, more subjective in nature. Versus a statutory residency test, which looks to whether or not the taxpayer has a permanent place of abode for substantially part of the year and spends more than 183 days in the state or city. For New York, we've seen the continued application of the convenience of the employer rule, which my personal opinion is I have very negative thoughts about York's Convenience of the Employer Rule. I don't like it at all. For those of you who don't know, it's a situation where if you're a New Jersey resident and you're based for work purposes in New York and you work from home in New Jersey on a particular day, New York will treat you and tax you as if you actually worked in New York that day.

So states like Connecticut and New Jersey are fighting back. New Jersey recently came up with its own convenience of the employee rule, although it says it doesn't have one, which is paradoxical. But so under New Jersey's rule, it says if an individual is a resident of New York, and they are based in New Jersey with a New Jersey employer and they work in New York from home for their own convenience, that would be considered a New Jersey day. But New Jersey's rule only applies if the state in which the individual's actually working has a convenience of employer rule, which obviously New York does.

Some transaction consideration regarding residency. Planning may be possible, if a big disposition is on the horizon, one can always change their residency. We can advise on what might be needed to officially change a residency. And there are many disconnects between state and federal, for example, in New York and New Jersey, where you could be a New Jersey C-corp and a federal S-corp, there could be some planning there. That's one of the ideas that we're working on among others where there's disconnects between federal reporting and state reporting.

Bella Brickle: Polling Question #5.

Denisse Moderski: Yeah, I see a question here. I believe someone brought this up on the November 3rd presentation. I know has mentioned about the market-based sourcing rules now applying to financial services area. So someone asked a question, to clarify how does this apply to funds? And I'm assuming this is for New Jersey, the question. If it's for New Jersey, they're asking how does it get sourced for New Jersey? Does it go to the funds investors where they're located or where the company provides the services? So for New York State purposes, if it's a partnership, it will be based on where the services performed. But for New Jersey with the change, it would be look through where those investors of the fund are located. So you could essentially end up with taxing more than 100%. If you have all your work performing New York and you have New Jersey investors at the fund level.

Thank you everyone.

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