While Congress develops legislation that would eliminate, and/or otherwise mitigate, the current TCJA implemented state and local tax (SALT) limit on an individual taxpayer’s ability to take the itemized deduction for state and local taxes, California has just passed legislation which offers a work-around that will allow many Californians to mitigate the effects of the current $10,000 federal limitation on SALT deductions.

On 7/16/2021, Governor Newsom signed into law AB-150, which provides a means by which certain pass-through entities (Qualified Entities) can make an election to pay California income tax (at the entity-level) on behalf of their owners, for which their consent must be given. The benefits yielded could be substantial for pass-through entity owners for which work-around makes sense. Curiously the IRS has approved these elective entity-level state tax mechanisms in IRS Notice 2020-75. While, on the surface, AB-150’s elective tax work-around appears to be a grand slam for California residents, the usual unknowns abound which are addressed below.

Elective Pass-Through Entity Tax

For tax years 2021-2025, a qualified:

• S corporation,
• partnership, or
• LLC taxed as a partnership or S corporation

 

that:

• does business in California, and
• is required to file a California return

 

is afforded the ability to:

• elect to pay a pass-through entity tax at the rate of 9.3% on its “qualified net income”, and

• decrease the federal net income included on the owners’ K-1 by the amount of the CA pass-through entity tax paid.
  

 

What is basically happening is as follows:

Flow-Through Business Owner’s Federal K-1

• the Federal K-1 recipients is reducing their federal AGI rather than having a Schedule A state tax deduction that would be subject to the $10,000 SALT deduction cap.

 

Flow-Through Business Owner’s California K-1

• The California K-1 recipient will be reporting net income to California, which has not been reduced by the essentially duplicative state tax paid by the flow-through entity, and

• also receive a California tax credit equal to the state tax paid by the pass-through entity on behalf of the owner.

 

Example: ABC, Inc. (an S Corporation), has “qualified net income” (defined below) of $1,000,000. The single shareholder has a 100% interest. If the shareholder qualifies, and the election is made, the S Corporation makes a payment of $93,000 ($1,000,000 x 9.3%) to the FTB. The S Corporation then reports $907,000 ($1,000,000 – $93,000) of net income on the federal K-1. The California K-1 will report (1) $1,000,000 of net income from ABC, Inc. ($907,000 of federal net income to which the non-deductible $93,000 elective pass-through entity tax paid to the FTB by ABC, Inc. is added back), and (2) reflect a tax credit of $93,000 against the shareholder’s California income tax to make them whole for the duplicative pass-through entity tax already paid the S Corporation on the same income.

S Corp Entity-Level Data	Federal	California
Qualified Net Income		$1,000,000
Taxable Income	$907,000	$1,000,000
Pass-Thru Entity Tax Paid		$93,000

 

Shareholder Flow-Thru Data	Federal K-1	California K-1
Flow-Thru Taxable Income	$907,000	$1,000,000
Credit Against CA Tax		$(93,000)

 

Note: In the event the federal $10,000 SALT limitation, as was the law on 1/1/2021, is subsequently repealed, the elective pass-through entity tax will become void on the following January 1.

Qualified Net Income

“Qualified net income” is defined as:

• the sum of the pro-rata or distributive share of income of the entity’s owners that are individuals, trusts, or estates,
• that consent to have their share of income subject to the elective pass-through entity tax.

 

In the event that some of an entity’s owners do not consent:

• the entity may still elect to pay the tax, however
• the amount of qualified net income will be reduced by the non-consenting owners’ share of the entity’s income.

 

California Tax Credit for Owners

Consenting pass-through entity owners may also claim a non-refundable credit on the California return for the amount of tax paid on the owner’s pro-rata or distributive share of the pass-through entity’s net income. Non-residents and part-year residents are also afforded use of the credit without need for any proration. Because the credit is non-refundable, unused credits may result, and may be carried forward for up to five years.

Election Mechanics

The election is:

• made annually,
• is irrevocable, and
• can only be made on an original, timely filed return.

 

Observation: As of the time of this writing, it is not clear whether an extended return will be considered a timely filed return.

The only entities eligible to make the election are:

• S corporations,
• Partnerships, or
• LLCs taxed as a partnership or an S corporation

 

and only if:

• the entity’s shareholders/partners are not partnerships,
• the entity is not permitted or allowed to be in a combined return, and
• the entity is not a publicly traded partnership.

 

Observation: The pass-through entity tax is over-and-above any other tax/fee that the pass-through entity is ordinarily subject to.

Tax Payment Mechanics

Tax Year 2021

The pass-through entity tax must be paid by the due date of the 2021 tax return, without regard to extensions.

• i.e. 3/15/2022 for calendar-year taxpayers

 

Tax Years 2022 – 2025

The pass-through entity tax must be paid in two payments.

Payment #1

• June 15th (for calendar year taxpayers), or
• the 15th day of the 6th month of the taxable year (for fiscal-year taxpayers)

 

The dollar amount due is the greater of:

• 50% of the pass-through entity tax paid for the prior year, or
• $1,000.

 

Payment #2

The balance due must be paid by the entity’s original filing date deadline (March 15 for calendar-year taxpayers).

Observation: Electing partnerships and S corporations will find it difficult to file their returns on extension.

Example: XYZ Partnership elected to pay the pass-through entity tax in 2021 and 2022 on behalf of some of it’s partners.

• In 2021, XYZ Partnership paid an entity level tax of $10,000 by 3/15/2022.

 

• For the 2022 taxable year, it must pay $5,000 by June 15, 2022 (50% × 10,000). When it files its 2022 partnership return in 2023 it reports a total entity tax due of $12,000. XYZ Partnership must pay the remaining $7,000 by March 15, 2023.

 

If the entity fails to pay the amount due by June 15, the entity is prohibited from making an election to pay the pass-through entity tax for that year.

(This is Blog Post #1068)