Back in 2017, the Tax Cuts and Jobs Act was signed into law which instituted a cap on the amount of state and local taxes (SALT) that individuals could report as Itemized Deductions on Schedule A.  Starting with the 2018 tax year, the maximum SALT deduction available was $10,000. Previously, there was no limit.  Since then, roughly 20 states have come up with workarounds intended to negate, or at least mitigate the effect of the SALT limitation.

In 2021 California passed AB 150, which provides that, in the taxable years 2021-2025, a so-called “qualified entity” (a S corporation, partnership, or LLC taxed as a partnership or S corporation) to make an election to pay a new pass-through entity (PTE) elective tax equal to 9.3% of its “qualified net income”. The point of this gyration is that the payment of this tax by the PTE will decrease (without limitation) the federal net income ending up on owners’ K-1.  To eliminate the double taxation would otherwise occur for California purposes, California also allows the qualified entity’s consenting “qualified taxpayers” (individual, estate, trust, and now certain SMLLC owners) to claim a credit on their California return of up to 100% of the tax paid on their behalf by the “qualified entity”.

Why SB 113 is a Game Changer for the PTE Elective Tax

When the PTE elective tax was initially enacted by AB 150, there were three primary obstacles which made the election to pay the tax either not possible at all, or otherwise unappealing to many taxpayers:

• The PTE Elective Tax Credit was:

• • nonrefundable,
  • subject to a tentative minimum tax (TMT) limitation, and
  • when combined with a 5-year carryover limitation, it meant that it was possible that many taxpayers might not receive the full benefit of the credit in the year applied for, if ever were the carryover period to expire.

• Qualified Entities with owners that were partnerships were not able to make the election; and

• A Qualified Entity could not pay the tax on behalf of single member LLC (SMLLC) owners, even if
  the SMLLC was owned by an individual, estate, or trust (otherwise Qualified Taxpayers).

 

SB 113 retroactively fixes the foregoing issues, and others, as follows:

• SB 113 repeals the TMT limitation,
• SB 113 affords entities with partnerships as owners to make the election, and
• SB 113 allows SMLLCs owned by individuals, trusts, or estates to claim the credit,

 

all effective beginning with the 2021 taxable year.

The Mechanics of the PTE Elective Tax/Credit

• “Qualified (pass-through) Entities” (as defined below) making the election will pay, at the entity-level, the tax (at the rate of 9.3%) on behalf of “Qualified Taxpayer” owners (also defined below) that consent to this arrangement.

• As is customary with the treatment of state taxes paid, the tax is deductible on the federal return but not the state return. Therefore, the recipient of the K-1 has effectively reduced their federal AGI as opposed to having a state tax deduction on Schedule A, which would have been subject to the $10,000 SALT deduction limit.

• While, for federal purposes, the net income is reduced by the amount of the tax paid at the entity-level. For California, the state tax paid at the entity-level is added back to arrive at California taxable income on the California K-1.  To offset this, consenting owners will receive on their California K-1 a California tax credit of up to 100% of the state tax paid by the PTE on behalf of the owner.

 

“Qualified Entity” Defined

A “Qualified Entity” is defined as:

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

but only if the entity is not:

• permitted or allowed to be in a combined return, or
• a publicly traded partnership.

 

Originally, AB 150 prohibited entities from making the election if any one of their owners was a partnership. SB 113 however retroactively changed the law so that entities with partnership owners can now make the election starting with the 2021 tax year.  That said:

• the “qualified entity” cannot pay the tax on behalf of such partnership owner (see “‘Qualified Taxpayer’ Defined” later).

• Trusts are not “qualified entities”, therefore the PTE Elective Tax can’t be paid at the trust level. Trusts are however considered “qualified taxpayers”(see  “‘Qualified Taxpayer’ Defined” later).

 

Single Member LLCs (SMLLCs)

SMLLCs may not make the election, except under the following circumstances:

• they have elected to be taxed as an S corporation,

• they add a member, or

• when there is a married couple with a tax home in a community property state, they elect to be treated as a partnership.
  

 

Must be “Doing Business” in California

The entity must be “doing business” in California to make the election.  As such, there is a requirement that a California return be filed.  Therefore, even if an out-of-state entity has owners that are California residents, they cannot make the election if they are not considered to be doing business in California.

“Qualified Taxpayer” Defined

An electing entity can only pay PTE Elective Tax for the benefit of a “qualified taxpayer(s)”.  A “qualified taxpayer” is an:

• individual,
• trust, or
• estate

 

that is subject to California personal income that is a:

• partner,
• shareholder, or
• member

 

that has consented to have a “qualified entity” pay tax on their respective pro-rata or distributive share of the “qualified entity’s” income.

Changes made by SB 113:

Retroactive to the 2021 tax year:

• An SMLLC owned by an individual, estate, or trust is a “qualified taxpayer”

• As such, “qualified entities” are allowed to pay the PTE Elective Tax on behalf of the SMLLC “qualified taxpayer”, and in turn, the SMLLC’s owner would claim the credit on their return for the PTE Elective Tax paid by the electing “qualified entity”.

 

What a “qualified taxpayer” is not

A “qualified taxpayer” is not a corporation or other business entity and, as such, the “qualified entity” is not able to pay the PTE Elective Tax on behalf of such corporate or business owners.  This is inclusive of businesses that are disregarded entities for federal tax purposes (other than SMLLCs as previously discussed) .

Trusts

Trusts are confirmed by the FTB to be “qualified taxpayers”:

• eligible to claim the credit, and
• pass the PTE Elective Tax Credit through to it’s beneficiaries

 

Trusts in this context are inclusive of:

• grantor trusts, and
• intentionally defective grantor trusts

 

The PTE Elective Tax Credit would be reported to trust beneficiaries on the Form 541 K-1 at Line 13d (Other Credits).

“Qualified Net Income” Defined

The PTE Elective Tax is calculated as 9.3% of “qualified net income” . . . no more, no less. “Qualified net income” is the sum of:

• the pro-rata share, or distributive share, of income, plus
• any “guaranteed payments” of the entity’s individual, trust, or estate owners

 

provided that the owners:

• are subject to California taxation, and
• have consented to having their share of income subject to the PTE Elective Tax

 

Owners “Consent”, and Related Issues

Contrary to what you would think, there are no specific agreements that consenting owners must sign.  Because of this, it is recommended that “qualified entities” devise some sort of agreement that will be retained with their tax files.  The FTB is provided with the list of “consenting owners” via “Pass-Through Entity Elective Tax Calculation” (Form 3804), which must be submitted by “qualified entities” when they file their tax returns.

Note: Although it is optimal if all owners consent, the “qualified entity” may still elect to pay the tax even if some of its owners do not.  In this scenario however, it should be noted that the amount of “qualified net income” will be reduced by the non-consenting owners’ share of the entity’s income.

Expense allocation

For federal tax purposes, the PTE Elective Tax payments are treated as an expense of the pass-through entity at the entity level. In accounting parlance, this means that the payments are debited to PTE Tax Expense.

Unless as-yet-unissued guidance is forthcoming from the IRS, this means that the payments would be equally allocated to all owners based on their ownership percentage, even if they did not elect to have a payment made on their behalf. This translates into consenting qualified owners who essentially “paid to win” to get the higher state tax deduction will not be getting 100% of what they paid for.

As it currently stands, this will be a significant issue for S corporations that are only allowed to make distributions in accordance with ownership percentage lest they be charged with having a second class of stock, an S election terminator.  The AICPA submitted a letter to the IRS in they have recommended that the IRS issue regulations stating that these payments are treated similarly to non-resident withholding or composite tax payments under Reg §1.1361-1(l)(2)(ii). Doing so would allow the receipt of proportionate compensating distributions to non-consenting owners to make them whole without creating a second class of stock.

This issue is not an inherent deal breaker for Partnerships as they are permitted to specially allocate deductions (as long as this treatment is provided for in the partnership’s operating agreement).  However, these entities will have to compensate for the fact that these PTE Elective Tax payments were made for some partners and not others.

Treatment of Guaranteed Payments

Contrary to other states which include guaranteed payments in net income subject to the PTE Elective Tax, AB 150 originally excluded guaranteed payments from the calculation. Now, under SB 113, the inclusion of guaranteed payments in “qualified net income” is confirmed retroactively.

Treatment of Capital Gains and Other Investment Income

The PTE Elective Tax is paid on all income reported on the K-1 inclusive of interest, dividends, and capital gains.

Note: This means that if an entity is sold in an asset sale, the gain would be entity-level income included in the qualified entity’s “qualified net income” subject to the PTE Elective Tax. Alternatively, the sale of of a business via a stock sale would create owner-level income which is not subject to the PTE Elective Tax.

Non-Resident Income Sourcing Issues

In situations when a “qualifying entity” is owned by resident and non-resident shareholders, partners, members:

Resident Owner

• the “qualified entity” will include in its “qualified net income” calculation 100% of the consenting resident owners’ distributive or pro-rata share of income, and
  

Non-Resident Owner

• for non-resident owners, only their apportioned share of the entity’s California-sourced income is included in the entity’s “qualified net income”.

Computation of “Qualified Net Income”

Current FTB form instructions reflect that the pro-rata/distributive share of income can generally be computed as follows:

For S Corporation Shareholder

From K-1 (100S):

• the sum of lines 1–10,
• minus lines 11 and 12

For Partners

From K-1 (565/568):

• the sum of lines 1–3 and lines 5–11 (the sum of lines 1-11 after SB 113),
• minus lines 12 and 13

 

Generally speaking, this translates into a partner’s/shareholder’s share of the entity’s

• rental income,
• interest/dividend income,
• royalties,
• capital and IRC §1231 gains,
  
• less: §179 deductions,
• less: charitable contributions, and
• less: investment interest expense.

 

In addition, the FTB has confirmed that §743(b) adjustments are also included in the calculation of “qualified net income”.

Deducting the PTE Elective Tax on the Federal Return
(. . . the reason we are going through all of this!)

Year of Deduction on the “Qualified Taxpayer’s” Federal Return

Curiously, the IRS approved these type of SALT limitation workarounds in IRS Notice 2020-75 and stated regulations would be forthcoming to clarify the treatment of taxes on both the entity’s and owners’ returns. As of the time of this writing, no such regulations nor additional guidance have been forthcoming.

However, the notice did suggest that the PTE would deduct the tax in the year the tax is paid and that the tax payment would reduce the PTE’s distributable net income reported on the owner’s K-1 for the year the tax is paid, regardless of whether the “qualifying entity” is on the cash or accrual method of accounting.

Note: This means that a tax payment made in 2022 for the 2021 tax year:

• would be deducted on the “qualifying entity’s” 2022 tax return, and
• passed through to the “qualifying taxpayer” on the 2022 K-1.

Treatment of the Inevitable PTE Elective Tax Overpayments

What has not been addressed by the IRS is:

• whether a taxpayer that overpays the PTE Elective Tax in 2021 is limited to deducting the amount of tax that will actually be due, or

• whether they may claim the deduction for the amount actually paid in 2021, and then include in their 2022 taxable income any amount actually refunded.

 

Many tax observers have taken the position that continues the IRS’ cash-basis narrative and that, absent contrary guidance being issued by the IRS:

• the amount of tax actually paid should be deducted in the year actually paid (cash basis), and

• any overpayment refunded should be included as a taxable refund in the following tax year . . . the year actually received (cash basis).
  

Mechanics of Making the PTE Elective Tax Election

The election is:

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

 

The election is made on “Pass-Through Entity Elective Tax Calculation” (Form 3804) which is attached to the “qualified entity’s” tax return. Listed on Form 3804 is:

• all of the electing entity’s owners for whom the tax was paid, and
• the amount of tax paid on their behalf.

 

Timing of the PTE Elective Tax Credit

Contrary to the federal tax return deductibility regime, regardless of what year the tax is paid in:

• if a PET tax credit that is based on 2021 “qualified net income”, and
  
• an election is made with the 2021 tax return,

 

“qualified taxpayers” will take the credits against their 2021 California tax liabilities.

Note: Regardless of if the “qualified entity” does not pay the 2021 tax until the 2022 calendar year, the “qualified taxpayer” may claim the credit on his or her 2021 tax return. The credit is allowed in full for non-residents and part-year residents, with no proration required.

Timing of the Payment of the PTE Elective Tax

2021

For the 2021 taxable year only, the tax is due by the due date of the original return, without regard to extensions (March 15, 2022, for calendar-year taxpayers).

2022–2025

For the 2022 through 2025 taxable years, two payments must be made by the “qualified entity”.

• Payment #1 is due by June 15th of the taxable year in an amount that is the greater of:

• • 50% of the PTE Elective Tax paid for the prior year, or
  • $1,000

 

• Payment #2 (the remaining amount) is due by the “qualified entity’s” original filing date deadline (March 15 for calendar-year taxpayers).

 

Note: The accuracy of Payment #1 is critical because, if the June prepayment is underpaid, then the taxpayer is not allowed to make the election for that taxable year.

No exception to 50% requirement

At presents, no exceptions exist to the 50% of prior-year tax requirement for the June 15 payment.

The Tax is Exactly 9.3% . . . No More . . . No Less

Ramifications of Underpaying the PTE Elective Tax

For all years (2021 – 2025), in situations in which the amount ultimately paid by the original due date of the return (March 15 for calendar year taxpayers) are less than 9.3% of the “qualified entity’s” “qualified net income” calculated when the return is ultimately filed, the remainder will be due with the return when it is filed, and the “qualified entity” will be subject to penalties and interest on such underpaid PTE Elective Tax.

Procedures When the PTE Elective Tax is Overpaid

Once the “qualified entity” ultimately files it’s return, the overpaid amount will be refunded subject to any outstanding tax liabilities or offsets.

Mechanics of Making the PTE Elective Tax Payment

Payments Made by Check

Checks are sent with “Pass-Through Entity Elective Tax Payment Voucher” (Form FTB 3893). “Qualified Entities” should use the 2021 payment voucher for all payments made related to 2021 “qualified net income”, even if those payments are made in 2022.

Payments Made via WebPay

Alternatively, “qualified entities” may pay the tax through FTB WebPay.  Under this method, no Form 3893 is required.  WebPay payments can be made here:

https://webapp.ftb.ca.gov/webpay/login/belogin?Submit=Use+Web+Pay+business

Interaction with California e-Payment Mandates

A question that has already come up from taxpayers and tax practitioners alike is whether these payments subject “qualified entities” and it’s “qualified taxpayer” owners to California’s e-payment mandates.

Background: Individuals and corporations are subject to the California e-Payment mandate once they make:

• an estimate or extension payment exceeding $20,000, or

• file an original tax return with a total tax liability over $80,000.

Once the taxpayer meets this threshold, all subsequent payments regardless of amount, tax type, or taxable year must be sent electronically.

With regards to the PTE Elective Tax, keep in mind that these payments are made by the “qualified entity”, not the “qualified taxpayer” individual owner.  As such:

• they will never trigger mandatory e-pay for the owners, however

• they may trigger a mandatory e-pay requirement for the entities.

Partnerships and LLCs taxed as partnerships

These entities are not subject to the electronic payment mandate, so PTE Elective Tax payments made by these entities will never cause a mandatory e-pay requirement, regardless of the amount involved.

S Corporations

Already subject to the California e-Pay Mandate

With regards to S corporations making payments on behalf of consenting “qualified taxpayers”, if the S corporation had already previously triggered a mandatory e-pay requirement, the PTE Elective Tax payment must be made electronically.  Reason being that, once a taxpayer is subject to the e-pay mandate, all future payments are required to be made electronically.

Not yet subject to the California e-Pay Mandate

For S corporations not previously subject to the mandate, it should be noted that

• PTE Elective Tax payments are not considered estimated tax or extension payments, so they will not trigger the mandate if the payment is >=$20,000 but <$80,000.

• Moreover, PTE Elective Tax prepayments are not considered part of the “final tax liability,” so they won’t trigger mandatory e-pay there either.

• However, they will be included on the S corporation’s “final tax liability” when the S corporation’s return is filed, so the e-pay requirement may be triggered if the S corporation’s final tax liability (inclusive of the PTE Elective Tax) is over $80,000 when the return is filed.

This would mean that all payments made by the “qualified entity” subsequent to that return being filed must be paid electronically; it does not mean that the triggering payment itself must be made electronically.  Simple . . . right?

California PTE Elective Tax Related Credits to “Qualified Taxpayers”

“Qualified taxpayers” (owners) may claim a non-refundable personal income tax credit on the California return for up to 100% of the amount of the PET tax paid on their behalf by the “qualified entity” on the taxpayer’s pro-rata or distributive share of the PTE’s “qualified net income”.

Forms the “Qualified Taxpayer” will Use to Report the Credit

• The PTE Elective Tax credits will be reported to the “qualified taxpayers” (owners) by the “qualified entity” on Schedule K-1.

• The “qualified entity” will report to the FTB on “Pass-Through Entity Elective Tax Calculation” (Form 3804) the amount that each consenting owner (“qualified taxpayer”) is entitled to claim as a credit.

• The “qualified taxpayer” (owner) will claim the credit on “Pass-Through Entity Elective Tax Credit” (Form 3804-CR), which must be attached to the owner’s return.

Carryover of Unused PTE Elective Tax Credits

Unused PTE Elective Tax credits may be carried forward for up to five years, after which time they expire.

SB 113’s Removal of the Tentative Minimum Tax Credit Limitation

AB 150, as Originally Enacted

As originally enacted, the PTE Elective Tax Credit could not reduce a taxpayer’s California Tentative Minimum Tax (TMT). This significantly limited the amount of benefit that many taxpayers could actually utilize from this credit.

SB 113

Repealed this TMT limitation, retroactively beginning with the 2021 tax year, and in so doing completely change the landscape of this credit.

How the PTE Elective Tax Credit Interacts with Estimated Tax Payments

The PTE Elective Tax Credit is applied prior to estimated tax payments.  As such, taxpayers whose estimated taxes are overpaid due to the PTE Elective Tax being paid on their behalf will receive a refund of such overpaid estimated taxes.

Effect on Future Estimated Tax Payments

Although the PTE Elective Tax is not an estimated tax payment on behalf of the owner, it may serve to decrease the owner’s ultimate tax liability, meaning that a reduction in future estimated tax payment amounts may be warranted.

Other Related Matters

Even though we’ve provided a fairly comprehensive overview of the Pass-Through Entity Tax from all angles, there are still additional topics which are outside the scope of this post.  These tax concepts are also impacted by the PTE Elective Tax and/or the associated credit:

• Ordering of California Tax Credits
• California’s Other State Tax Credit (OTSC)
• $5M Business Credit Limitation
• California’s Net Operating Loss Suspension
• Withholding from Non-Residents

Other Resources

The Franchise Tax Board has available the following page where FAQs are posted addressing California’s Pass-Through Entity Tax:

Help with Pass-Through Entity Elective Tax

(This is Blog Post #1176)