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California's Pass-through Entity Tax Election – Providing Relief From The SALT Deduction Cap

California's Pass-through Entity Tax Election – Providing Relief From The SALT Deduction Cap

Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), taxpayers who itemized could annually deduct state and local taxes (SALT) paid on their personal federal tax returns. The TCJA added in IRC Section 164(b)(6), effectively placing a $10,000 cap on taxpayers' federal itemized SALT deductions.1 The cap on SALT deductions applies for tax years ending December 31, 2017 through December 31, 2025.2 In response to the SALT deduction cap, California instituted the California Pass-through Entity ("CA PTE") tax election. The CA PTE election allows California pass-through entities to pay their consenting owners' state tax annually and then book such payments as a business expense.3

What Is The California Pass-through Entity Tax Election?

California Gov. Gavin Newsom passed A.B. 150 on July 16, 2021, and added Cal. Rev & Tax Code §17052.10, which created the CA PTE. On February 9, 2022, S.B. 113 amended and corrected A.B. 150, which allowed S corporations and entities taxed as partnership (including LLCs) to apply for the CA PTE, effective for the tax years beginning January 1, 2021, and before January 1, 2026.4 The CA PTE tax election allows taxpayers to consent to have their share of a pass-through entity's qualified net income paid at the entity level, at a rate of 9.3%.5 When taxpayers elect to pay at the entity level, qualified taxpayers receive a credit for their share of taxes paid by the entity.6 Taxpayers will still pay their full California tax liability, but the 9.3% credit is then deducted as a business expense for federal income tax purposes.7

Initially, many taxpayers were hesitant to make a PTE election because A.B. 150 did not allow a taxpayer to use the credit to reduce their net income below the tentative minimum tax (TMT).8 Under S.B. 113, taxpayers can use the CA PTE election to reduce their net income below their TMT.9 Taxpayers can also carry forward any unused credit for 5 years, making the credit extremely attractive.10

Who Is A Qualified Taxpayer?

Any individual, fiduciary, estate, or trust that serves as a partner, member, or shareholder of a California pass-through entity subject to California personal income tax is a qualified taxpayer. Disregarded entities, publicly traded partnerships, and entities required to participate in a combined reporting group are not qualified taxpayers.11 The CA PTE election does not require all partners, members, or shareholders to opt-in. Once the election is made, the entity will pay the PTE tax on behalf of the electing participants.

When To Make An Election?

The election must be made annually. For tax years 2022 through 2025, the PTE election must be made when the tax return is filed.12 An initial payment of $1,000 or 50% of the elective tax paid in the prior taxable year must be made no later than June 15.13 The remaining amount due must be paid on or before the tax return's original due date.

Advantages Of Making The Election

For taxpayers choosing to make a CA PTE election, there are a number of advantages: (1) the credit can be applied to reduce a taxpayer's tentative minimum tax (TMT);14 (2) taxpayer's share of the entity's qualified net income is taxed at the business level 9.3%;15 (3) taxpayer receives a credit for their share of the entity level tax ; (4) any unused credit may be carried forward by the taxpayer for five years;16 and in accordance with IRS Notice 2020-75, tax payments made by an entity under a state's PTE rules can qualify as "specified income tax payments" and may be "deducted by partnerships and S corporations in computing non-separately stated income or loss".17

General Business Considerations

There are several business considerations taxpayers should evaluate before making the CA PTE election. First, the election is made on an annual basis.18 Once made, the election is binding on the entity, even if all taxpayers did not consent, and it may not be rescinded for that tax year. Second, while all taxpayers of an entity are not required to make the CA PTE election, the qualified net income for purposes of the election only includes the share of income and guaranteed payments of the consenting taxpayers.19 Third, nonresident withholding is still required.20 One potential issue taxpayers will face is that S.B. 113 does not remove the required nonresident withholding of 7%.21 That mixed with the CA PTE 9.3% withholding for the pass-through entity elective tax would effectively leave nonresidents paying 16.3% absent a nonresident withholding exemption.22 Fourth, the $5M business credit utilization limitation still applies to the CA PTE.23 Lastly, S.B. 113, which amended AB 150, states that CA PTE tax credits come secondary to any other state tax credits.24

Considerations for S-Corps

In accordance with IRC section 1361, all S-Corp shareholders must have equal rights to distribution and liquidation. A constructive distribution by the S-Corp is still considered a distribution.25 This means that should the Company pay the tax liability for any consenting shareholders and not others, those shareholders could be deemed to have received a distribution. Such a distribution, one could argue, would be an unequal distribution effectively creating a second class of stock and compromising the S-Corp status of the entity.

While the AICPA has sent some potential workaround suggestions to the IRS concerning the potential issue for S-Corps, the IRS has yet to respond.26

Taxpayers with questions about the California PTE Election should contact Morgan Gray or the Hanson Bridgett Tax Group.

1 Tax Cuts and Jobs Act of 2017, Pub. L. No. 115-97 (2017).
2 IRC § 164(b)(6).
3; see also CAL. REV. & TAX. CODE §§ 17052.10(a)-(b)
4 One of the biggest changes from S.B. 113 is that it amended CAL. REV. & TAX. CODE §17039(c)(1), to allow the CA PTE tax credit to reduce a S-Corps TMT. See also CAL. REV. & TAX. CODE §17052.10(a)
5 Ch.3 (S.B. 113), Laws 2022. see also CAL. REV. & TAX. CODE §19900(a)(1).
7 IRC § 164(b)(6); see also H.R. Rep. No. 115-466, at 260 n. 172 (2017).
8 A.B. 150, signed July 16, 2021.
9 Ch. 3 (S.B. 113), Laws 2022.
10 CAL. REV. & TAX. CODE § 17052.10(c).
14 CAL. REV. & TAX. CODE §17039(c)(1)(AD).
15 CAL. REV. & TAX. CODE §19900(a)(1).
16 CAL. REV. & TAX. CODE §17052.10(c).
17 IRS Notice 2020-75, Section 3. Forthcoming Proposed Regulations.
18 Ch. 3 (S.B. 113), Laws 2022.
20 CAL. REV. & TAX. CODE §17039(b).
23 A.B. 85, signed June 29, 2020.
24 Ch. 3 (S.B. 113), Laws 2022 and CAL. REV. & TAX. CODE § 17039(a)(7).
25 Estate of Sell, T.C. Memo. 1992-430; Gow, T.C. Memo. 2000-93, aff'd, 19 Fed. Appx. 90 (4th Cir. 2001).
26 AICPA 2021 Tax Policy & Advocacy Comment Letter: Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes (October 26, 2021).

For More Information, Please Contact:

Morgan Gray
Morgan Gray
Los Angeles, CA