New York’s Response to Federal Tax Reform: Optional Payroll Tax
In an effort to mitigate the effects of the elimination of the individual SALT deduction as part of federal tax reform, New York has enacted an optional payroll tax that would allow employees to receive a personal income tax credit against their New York income tax liability. The underlying economics of this provision are complex, however, and could make implementation difficult.
New York is the first state to pass legislation aimed at mitigating the effects of the federal elimination of the state and local tax deduction for individuals as part of federal tax reform. The changes came in two parts: (1) the enactment of an optional payroll tax, discussed in this article, and (2) enactment of a charitable contribution regime, discussed in a separate On The Subject.
The idea of the payroll tax is simple: the employer pays a payroll tax, and employees receive a personal income tax credit against their New York income tax liability based on wages subject to the payroll tax. The underlying economics are anything but straightforward, however. Employers bear the cost of paying the new tax (should they decide to do so) while employees reap the benefit in the form of reduced New York State taxes. Employers opting into the tax might attempt to decrease employee compensation to mitigate the effect of the new cost to their business, even though the statute does not allow this to be done explicitly. Needless to say, lowering wages, albeit in a way that is intended to help employees, may be a tough sell to the employees. This will be made even more difficult for employers that have employees who are not New York residents, because those nonresident employees will not receive any benefit if their state of residence does not provide an offsetting credit for the optional payroll tax paid by the employer.
In addition, any reduction in wages could affect other benefits that are based on wages, such as defined benefit pensions, social security and allowable 401(k) contributions. Even assuming a willingness on the part of employers and employees to work through the regime, calibrating the correct fluctuation in wages may be impossible from a practical perspective. Ultimately, it will be interesting to see how many employers decide to opt into the new tax.
The new provision allows employers to opt into payment of payroll tax. Tax will be paid on wages paid to each employee that exceeds $40,000/year. Employees will be provided with a credit against New York State personal income tax based on wages in excess of $40,000. This structure does not necessarily produce a dollar for dollar offset of federal taxes.
The optional payroll tax has a three-year phase-in starting in 2019:
- 2019 rate – 1.5 percent of payroll expense
- 2020 rate – 3 percent of payroll expense
- 2021 rate – 5 percent of payroll expense
Payroll expense would mean wages and compensation as defined under IRC §§ 3121 and 3231.
The law provides a personal income tax credit for an employee equal to the product of (1) the employee’s taxable wages and compensation in excess of $40,000 received from the employer, (2) the optional payroll tax rate (1.5 percent for 2019), and (3) the result of one minus a fraction, the numerator of which is the New York State personal income tax imposed on the employee (before application of any credits) and the denominator of which is the employee’s state taxable income. The credit is independent of the payment of the payroll tax by the employer.
Credit would apply for the same year in which the payroll tax is paid (i.e., 2019 payroll tax payment would affect the employee’s 2019 New York State income tax credit). The anticipated federal benefit would relate to the same tax year in which the payroll tax is paid, i.e., 2019 payments would affect the employee’s 2019 federal tax liability (2019 return filed in 2020).
Payroll tax payments would be due at the same time personal income tax withholding payments are remitted.
Making the Election
Election must be made on or before December 1, to take effect for the immediately succeeding calendar year. Elections made after December 1 would take effect in the second succeeding calendar year.
If the employer is a corporation, any officer or manager of the employer who is authorized to make the election may do so.
New York Wages
The payroll tax applies to payments made to those employees who are currently subject to New York withholding on their wages; accordingly, the payroll tax would apply to payments made to New York State nonresident employees. The statute is unclear, however, as to whether withholding would have to be paid only on that portion of a nonresident’s wages that are earned in New York.
The law imposes the payroll tax on the “payroll expenses” paid to all “covered employees.” This lack of clarity as to wages that are subject to the tax arises from the definition of covered employee and the lack of any defining limitation on payroll expenses that are subject to the tax. A “covered employee” is defined as any person for whom the employer is required to withhold New York taxes from wages, meaning that the employer would need to pay the tax for wages paid to nonresidents with any New York source income earned from the employer.
“Payroll expenses,” however, are defined without a limitation for New York source income as follows: “Payroll expense means wages and compensation as defined in sections 3121 and 3231 of the internal revenue code (without regard to section 3121(a)(1) and section 3231(e)(2)(A)(i)), paid to all covered employees.” This definition makes sense for a New Jersey resident who works in New York and earns all of his or her wages in New York. However, it is unclear how this provision would apply to, for example, a Virginia resident that earns 50 percent of his or her wages from New York and 50 percent from Virginia. The state could arguably assert that the payroll tax applies to all of that employee’s wages, although this likely was not the intent.
Because “covered employees” are defined as those for whom the employer is required to withhold for New York purposes, employers would not be required to pay the tax for payments to nonresident employees earning none of their income in New York. For example, an employer would not be required to pay the tax for a Virginia employee earning all of his or her wages in Virginia.
Employees who are nonresidents of New York State may not get any benefit from the payroll tax because their state of residence may not provide a credit against the personal income tax for the payroll tax paid to New York State by the employer.
New York City
No similar New York City payroll tax applies.
Some are speculating that it would be expensive for a company to elect to pay the payroll tax and that therefore the provision may be difficult to implement. Consequently, few employers may choose to opt in to the payroll tax. One possibility would be to place a small group of employees in a separate corporation or limited liability company and have that entity make the election. The election appears to be made on a separate entity basis, even for members of combined return groups.