California is one of the latest of several states to enact a state and local tax (SALT) cap workaround by instituting an elective pass-through entity (PTE) tax to provide business owners with some relief from the $10,000 Federal cap on SALT deductions.
In guidance issued last November, the IRS consented to this technique, which allow PTEs to pay state income taxes on behalf of their owners. The entity fully deducts the taxes in calculating Federal taxable income passed through to its owners. The end result is roughly the same as if the owners had paid the taxes and deducted them on their individual returns, without limit.
Qualified Entities for the California SALT Workaround
For tax years beginning on or after January 1, 2021, and before January 1, 2026, qualified entities which owe California income tax can take advantage of the SALT cap workaround by electing to pay California income tax of 9.3% on their consenting owners’ pro rata or distributive share of the entity’s income (California’s source income for nonresident owners). Qualified entities are S corporations and businesses taxed as partnerships (limited partnerships, LLCs and LLPs), that include as owners:
- Trusts, and
California entities with a partnership as an owner are disqualified from utilizing the SALT cap workaround. Also excluded are publicly traded partnerships and entities that are permitted or required to be in a combined reporting group.
The California pass-through entity tax can be remitted on income of qualified taxpayers. Although the partnership itself may be qualified to make the election, partners such as corporations and business entities that are disregarded for federal tax purposes may not be eligible for the PTE. (Clarification is pending from the State of California as to whether or not this disregarded business entity provision will apply to a disregarded entity owned by an individual.)
Timing of Payments
The PTE tax is an annual election and is irrevocable. It is made on an original, timely filed California return (without extensions) in order for the PTE to benefit from the SALT cap workaround. Unanimous owner consent is not required. The entity pays PTE tax only on behalf of consenting owners.
For tax years beginning in 2021, the tax must be paid by the unextended tax return due date (March 15, 2022, for calendar-year taxpayers). For tax years beginning in 2022 through 2025, entities must make an estimated tax payment by June 15th of the taxable year of the election. The payment needs to be equal to the greater of $1,000 or 50% of the PTE tax paid in the prior year. The balance, if any, is due by the unextended return due date. Failure to make the estimated payment disqualifies entities from making an election that year.
To avoid double taxation of the same income, consenting owners receive a nonrefundable credit against their California income tax liability equal to the PTE tax paid on their behalf, not to exceed their qualified income multiplied by 9.3%. If the credit exceeds their tax liability, they may carry over the excess for up to five years. Owners in California tax brackets lower than 9.3%, or who otherwise believe the credit will exceed their tax liability, should consider the potential cost of unused credits in determining whether to consent, in order to receive the benefit of the SALT cap workaround.
The bill enacting the PTE tax (A.B. 150) left some questions unanswered which will require guidance from the California Franchise Tax Board. It is unclear whether an S corporation whose owners don’t all consent to the PTE tax or have owners that are nonresidents, have created a second class of stock, jeopardizing its S-corporation status. It is also unclear if California will allow a credit for another state’s PTE and if that credit will be limited.
What is certain, is that if Congress repeals the SALT cap workaround before it sunsets at the end of 2025, the California PTE will be repealed, automatically.
Although entities with partnership owners are ineligible for the PTE election, there may still be restructuring opportunities that allow them to qualify.
We will keep you informed as updates occur. For more information about the California PTE tax, contact your Untracht Early advisor.