The New York Department of Taxation and Finance has issued a much anticipated tax memorandum clarifying how its new, optional employer payroll tax will function. New York’s recent budget contained various provisions aimed at mitigating some of the adverse effects of the Tax Cuts and Jobs Act (P.L. 115-97), particularly with respect to the $10,000 federal limitation on state and local tax deductions. One novelty under the state's provisions is an employer payroll tax whereby employees would be eligible for a credit against their personal income tax, which is based on the payroll taxes paid by an electing employer.
What is the Employer Compensation Expense Tax (“ECET”)?
Under the ECET system, employers, including corporations, limited liability companies, partnerships, trusts, and other entities, may elect to pay certain payroll taxes on wages for employees earning more than $40,000 per year. The ECET shifts a portion of employees’ New York income tax burden to employers. The tax is being phased in over three years beginning in 2019 at a rate of 1.5% in 2019, increasing to 3% in 2020, and topping off at 5% in 2021. Employers have until December 1 to opt in for the next calendar year. If an election is made after the December 1 deadline, it will not take effect until the second succeeding calendar year. The ECET must be electronically paid on April 30, July 31, October 31 and January 31 of each year.
Which Employees are Covered?
Since only "covered" employees are eligible to receive a credit against their personal income tax, determining who qualifies as an employee will be based on the same criteria used with respect to the Metropolitan Commuter Transportation Mobility Tax. Specifically, the location of an employee’s work, the employee’s base of operations and the employee’s place of direction and control are all considered. The tax itself becomes applicable once a covered employee’s wages surpasses the $40,000 threshold. Employees working in various states are subject to the ECET only when, and to the extent, their New York compensation exceeds $40,000. Accordingly, some have explained that this provision does not prevent an employer from reducing the compensation of covered employees to reflect the employer’s payroll tax liability. Rather it means the ECET cannot be treated as a subtraction from wages for purposes of calculating other state payroll taxes, such as unemployment taxes.
What is the ECET Procedure?
An employer must make an affirmative annual election to participate in the ECET via a web-based registration system. The election applies to all “covered” New York employees, such that an employer is not permitted to exclude certain employees from the payroll tax.
New York is not adjusting its withholding tax table for electing employers. Rather, the 2019 Form IT-2104, Employee’s Withholding Allowance Certificate, will be updated to allow employees whose wages are subject to the ECET to adjust their tax withholding on a prospective basis.
It is also important to note that ECET is imposed on the electing employer—not on employees. Accordingly, employers would be subject to any ECET-related penalties and interest for late filing and late payment of the tax. Furthermore, employers would be eligible to claim a refund for any overpayment of the payroll tax.
A number of issues remain unresolved following the issuance of the state’s guidance on the ECET as it applies to both employers and employees. For example, the tax’s provisions mandate that an employer cannot deduct from compensation any amount that represents a portion of ECET imposed on the employer. Few employers are likely to elect such a tax, at a high administrative cost, whereby they just end up paying more out of pocket – the employee’s wages in addition to the new ECET. Accordingly, some it has been explained that this provision does not prevent an employer from reducing the compensation of covered employees to reflect the employer’s payroll tax liability. In addition, the ECET cannot be treated as a subtraction from wages for purposes of calculating other state payroll taxes, such as unemployment taxes. However, if an employer chooses to take the ECET into account by reducing compensation, it negatively impacts other employee wage-based benefits, including Social Security, 401(k) contributions and defined benefit pension plans.
Another looming question is how the ECET regime would affect New York nonresident employees based on the interaction with credits in their home 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. If a New Jersey resident works in New York, he will be subject to New York income tax on those wages earned in the state, but will be entitled to a credit in New Jersey for those taxes paid to New York. If the individual’s employer elects to be subject to the ECET, the New Jersey credit will be reduced by the amount of taxes paid under the new tax regime, leaving the employee worse off. The problem is further complicated if the employer chooses to reduce current compensation to mitigate the effect on the ECET.
At first blush, ECET would appear to have little practical application and to be without broad appeal to employers and employees alike. Implementing the ECET is expected to be an additional expense for employers, as both substantial financial and administrative expenses may be incurred in setting up systems to accommodate the payroll tax regime. Also, employees are sensitive to take-home pay for cash flow purposes, and any downward adjustments may be met with strong push-back. Furthermore, wage reductions can adversely impact fringe benefits, and employee and union employment contracts would likely have to be renegotiated.
Since the current guidance focuses on the employer’s side of tax, additional information is anticipated to explain the application to employees. Should you have questions about the ECET and its impact on you, as an employee or employer, please contact:
Principal, Director of State and Local Taxation
Principal State and Local Taxation and Tax Controversy