Since the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, individuals who itemize their federal tax deductions have been limited to a $10,000 deduction for state and local income taxes (“state taxes”). This has impacted taxpayers in high tax states such as California, New Jersey, and New York.
California’s Elective Pass-Through Entity Tax Explained
A pass-through entity (“PTE”) tax is meant to be a workaround for the federal $10,000 state tax limitation. It imposes an income tax directly on the PTE that is available as a non-refundable credit on the individual’s state tax return. The validity of a PTE tax has been scrutinized by the IRS, which left many states hesitant to adopt such a tax. In November 2020, the IRS issued Notice 2020-75, which announced the IRS’ intent to allow the PTE deduction in future regulations, validating the PTE strategy to avoid the federal $10,000 state tax limitation.
New Tax Rules
On July 16, 2021, California joined the ranks of 13 other states that have PTE taxes when Governor Gavin Newsom signed California Assembly Bill 150 (“AB 150”). While California is the most recent state to pass such legislation, various other states currently have PTE tax bills pending, with most expected to be adopted.
On February 9, 2022, Governor Gavin Newsom signed Senate Bill 113 (“SB 113”), which included multiple taxpayer friendly amendments to CA’s PTE tax. Please see below for a summary of CA’s PTE tax election as amended by SB 113.
How Does CA’s PTE Tax Work?
For tax years beginning on or after January 1, 2021 and before January 1, 2026; qualified entities can make an irrevocable annual election to pay a 9.3% tax on the sum of each qualified taxpayer’s share of the PTE net income for the elected tax year.
Through the PTE’s payment of the elective tax, each qualified taxpayer will be allowed a nonrefundable credit against their CA income tax liability – which can be carried forward for up to five years if the credit exceeds the taxpayer’s CA tax liability in the year of the election.
SB 113 amended AB 150 such that the PTE tax credit can now reduce a consenting taxpayer’s CA net income below their tentative minimum tax. This change significantly increased the number of taxpayers that may benefit from making the PTE tax election.
However, it should be noted that CA’s $5M business credit utilization limitation applies to the PTE tax and may limit taxpayers’ ability to utilize PTE tax credits in the year generated fully.
Qualified Entities for CA’s PTE Tax
Qualified entities must do business in CA and taxed as a partnership or S corporation. This includes limited liability companies elected to be taxed as a partnership or S corporation.
SB 113 has amended the definition of “qualified entity” to now include PTEs that have partnerships as owners.
However, publicly traded partnerships, and entities required to be in a combined reporting group still do not qualify to make CA’s PTE tax election.
Qualified Taxpayers for CA’s PTE Tax
Qualified taxpayers include any individual, fiduciary, estate, or trust subject to CA’s personal income tax that consent to have their pro rata share or distributive share of income taxed at the PTE level.
SB 113 amended the definition of “qualified taxpayer” to include single-member LLCs (SMLLCs) owned by an individual, estate, or trust. SMLLCs can now consent to the PTE tax and the owner of the SMLLC will receive the PTE tax credit.
However, even with the changes from SB 113, partnerships are still not considered “qualified taxpayers” such that tiered partnerships will be limited to making the election and receiving the credit at the lowest tier level.
It should be noted that a PTE with non-consenting owners may not limit the PTE’s ability to make CA’s PTE tax election. However, in the S corporation context, there is a potential pitfall that strongly suggests that all S corporation shareholders must consent. In cases where less than all S corporation shareholders consent, this introduces the possible violation of the corporation’s subchapter S status/election.
Qualified Net Income
SB 113 has expanded the definition of “Qualified Net Income” (“QNI”) to include guaranteed payments now when determining the qualified taxpayer’s 9.3% PTE tax liability. Additionally, the FTB provided guidance via their FAQ website as to what lines of a K-1 are includable in qualified net income.
For qualified taxpayers qualified net income is:
S corporations = sum of K-1 lines 1 to 10, minus lines 11 and 12
Partnerships = sum of K-1 lines 1 to 11, minus lines 12 and 13
How Do Qualified Entities Pay CA’s PTE Tax?
For tax years beginning on or after January 1, 2021, and before January 1, 2022, CA’s PTE tax is due on or before the due date of the return without regard to any extensions. For calendar year filers, the 2021 tax year deadline is March 15, 2022.
For tax years beginning on or after January 1, 2022, and before January 1, 2026, the PTE tax must be paid in two installments. The first installment is due on or before June 15th of the current tax year and is the greater of $1,000 or 50% of the elective tax paid in prior year. The second installment is due on or before the due date of the return without regard to any extensions.
The FTB has clarified regarding the 2021 PTE tax election, that the PTE tax election will not be invalidated if the PTE tax is underpaid after March 15, 2022 and the PTE return has been extended.
However, the PTE tax election will be deemed invalid if the PTE underpaid the first installment for the 2022 PTE tax.
Qualified entities and their owners will need to evaluate the tax implications of making this election on a yearly basis. Ample time should be provided to evaluate the election’s benefits and obtain consent from eligible taxpayers. The current recommendation is that both the qualified entity and qualified taxpayer sign a written consent for each applicable year the PTE tax election is made.
As is common with new tax laws, there are still areas that need clarification, so we remain waiting for additional guidance from the Franchise Tax Board. Additionally, due to the changes from SB 113 the required PTE tax forms to be filed remain in draft form as of today and could have further changes until finalized.
In the meantime, we recommend working with a state and local tax expert to determine if your business should make the PTE election, and what owners should consent to the election. Get in touch with our state tax team today to get started.
The above is intended to be an overview of the current law that exists at the time of release. It is not intended to cover every aspect of the PTE election, and your tax advisor should be consulted to discuss your specific facts and circumstances.