New York State recently established the Employer Compensation Expense Program allowing employers to elect to pay an Employer Compensation Expense Tax on payroll expenses paid to covered employees, which in turn allows the employees to take a credit against their New York State personal income tax. Employers must make the initial annual employer election by December 1, but due to several factors and unanswered questions, many employers have steered clear of the program.
The 2017 federal tax legislation, commonly referred to as the “Tax Cuts and Jobs Act,” caps an individual’s itemized deduction for state and local taxes at $10,000 per year for tax years beginning after December 31, 2017 through 2025. In an effort to mitigate the effects of this deduction limitation, the New York State (NYS) legislature established the Employer Compensation Expense Program (ECEP) in the state’s 2018–2019 Fiscal Year Budget Bill, which was signed into law on April 12, 2018 by Governor Andrew Cuomo. Subsequently, the NYS Department of Taxation and Finance issued guidance further explaining the provisions of the ECEP.
ECEP and the Employer Compensation Expense Tax
The intent behind the ECEP is to allow employers that have no cap on their corporate state and local tax deduction to assume their employees’ state tax liability. In effect, any federal-level state and local tax deduction lost by an individual employee due to the $10,000 cap would be made up by shifting the lost deduction to the employer, who would presumably still be able to take the deduction.
The ECEP attempts to facilitate this purpose by establishing a new optional Employer Compensation Expense Tax (ECET) that employers can elect to pay. Specifically, electing employers remit a tax on payroll expenses paid to covered employees. Such payments must be made quarterly at the same time the employer is required to remit payments of personal income tax withholding. In addition, electing employers must file quarterly ECET returns on the same date as withholding tax returns are due. An employer is specifically prohibited from deducting or withholding from an employee’s wages any portion of the ECET that is paid. In addition, an employer is prohibited from using any tax credit to reduce the amount of the ECET due.
For such purposes, payroll expenses refer to wages and compensation, as defined under the Internal Revenue Code §§ 3121 and 3231, paid to all covered employees. A covered employee is an employee of an electing employer who is required to have amounts withheld under NY Tax Law § 671 and receives annual wages and compensation from the employer in excess of $40,000 annually. Accordingly, the ECET applies to payments made to both NYS resident and non-resident employees.
The tax is phased in over a three-year period, at the following rates:
- 1.5% of payroll expense in 2019
- 3% of payroll expense in 2020
- 5% of payroll expense in 2021
Employers Must Elect to Participate by December 1
To participate in the ECEP, an employer must make an affirmative election annually by December 1 to opt in for the next calendar year. Thus, the initial annual employer election must be made no later than December 1, 2018 to participate for 2019. If an election is made after the deadline, it will not be in effect until the second succeeding calendar year. Once made, the election is not revocable and will remain in effect for the entire election period.
The election may be made by (1) an authorized officer or manager, if the employer is a corporation; (2) any member, owner, or other individual with authority to bind the entity or sign returns, if the employer is not a corporation; (3) the unanimous consent of all the trustees, if the employer is a trust; or (4) the chief executive officer, if the employer is a government entity. For these purposes, “employer” refers to an employer that is required to deduct and withhold taxes from wages under NY Tax Law § 671.
Covered Employees May Claim a Tax Credit Against NYS Personal Income Tax
Covered employees of an electing employer may claim a partial tax credit against their NYS personal income tax. The allowed credit is equal to the portion of the employer’s tax attributable to the employee, multiplied by one minus a fraction, the numerator of which is the NYS personal income tax imposed on the employee (before the application of any credits) and the denominator of which is the employee’s state taxable income. The credit is not refundable; however, any unused amounts may be carried forward to subsequent years.
Practical Considerations and Concerns
Despite the issuance of guidance by NYS, there are still a number of issues that remain unresolved with the ECEP, causing many employers to be cautious about electing into the program.
Electing employers will bear additional out-of-pocket costs by opting in to the ECEP, which may dissuade many employers from the election. Employers may incur administrative costs, including increased payroll tax expenses, costs associated with administering the ECET, and the potential for the imposition of penalties. Moreover, employers will bear more costs because they are specifically prohibited from deducting or withholding from an employee’s wages any portion of the ECET that is paid and are prohibited from using any tax credit to reduce the amount of the ECET due.
In addition, it is unclear how the mechanics of the ECEP and ECET will pan out. For example, nothing in the statute or guidance prevents an employer from reducing the compensation of covered employees to reflect the employer’s payroll tax liability.
Furthermore, it is unclear how the Internal Revenue Service (IRS) will treat the ECET. While to date, the IRS has not released a position on the ECET, it is possible that the IRS may potentially challenge the tax, in light of the IRS response to other state actions that it perceived to be an attempt to circumvent the state and local tax deduction cap.
Finally, employers should consider the impact of the ECET election on employees who are not NYS residents due to the interaction of the ECET with credits allowed in their resident states. A state generally imposes income tax on all of the income of its residents, regardless of where it is earned, but will offer a credit against the income taxes paid to other states. Since the ECET credit reduces the employee’s personal income tax paid to NYS, an employee who is not a resident of NYS may have their resident state credit reduced, and the employee may not gain any benefit from the ECET.
We will continue to monitor the impact of the ECEP and ECET and provide further information on material developments.