Governor Newsom signed California Assembly Bill 150 into law on July 16, 2021. This new California pass-through entity tax law allows owners of pass-through entities (PTEs) to avoid the federal cap on state and local tax (SALT) deductions for individuals. The legislation essentially enables California taxpayers who own PTEs to receive a credit for their share of the PTE-level state and local tax deductions they claim as partnerships and S corporations, allowing them to exceed the $10,000 state and local tax deduction limits. The goal for this new PTE tax is to provide tax relief for small businesses during the economic hurdles introduced by the COVID-19 pandemic.
The new California pass-through entity tax law is effective on tax years beginning on or after January 1, 2021, and ending before January 1, 2026. It will allow many partnerships and limited liability companies, that are taxed as partnerships and S corporations, to pay tax at an entity level tax based on an individual owners’ share of income. It then grants the owners a credit against California personal income tax for the full amount of tax paid at the entity level on their distributive share of California taxable income.
PTE Election Qualification
Pass-through entity eligibility requirements to qualify:
- The owners MUST consist solely of individuals, fiduciaries, trusts, estates, or entities taxable as corporations. Thus, the entity cannot have a partnership as an owner.
- The entity cannot be a publicly traded partnership.
- The entity cannot be included in a California combined report.
Elective Entity Tax
Eligible entities that qualify will pay a 9.3% tax on the total of each consenting owner’s pro-rata share of the entity’s income subject to California tax. For California residents, it includes all of their distributive share of income. For nonresidents, it includes all of their distributive share of California source income. An individual owner can determine whether or not they want their income included when the entity makes this election. The consent of all owners is not required in order for the entity to make the election. However, the election is irrevocable and must be on an annual basis on a timely filed return for the year of the election.
Timing of Payment of Elective Tax
For 2021, the elective tax is due on or before March 14, 2022. For taxable years 2022 through 2025, the elective tax is due in two installments:
- The first installment is due by June 15th of the current year, and is the greater of $1,000 or 50% of the elective tax paid in the prior year; and
- The second installment for the remaining amount is due on or before March 15th of the subsequent year.
Failure to make timely payments will invalidate the election.
Claiming Owner Credits for California Pass-Through Entity Tax
Consenting owners of the entity making the election will claim a credit on their California tax return equal to 9.3% of tax paid by the entity on the owner’s share of income subject to tax in California. However, credits in excess are allowed to be carried forward for up to five years. A consenting nonresident or part-year resident owner may face limitations on claiming California credits, including the renter’s credit and the credit for taxes paid to other states.
Owners who are not able to claim the credit in the initial year may carry the credit forward for 5 years. California taxpayers are also eligible to take this credit in its entirety if they are nonresident or part-year residents. Owners, members, and partners are excluded from claiming the credit if they are part of a business entity that is disregarded for tax purposes.
If the federal cap on SALT deductions is removed, the law automatically repeals itself and an entity’s ability to claim this election goes away. This California pass-through entity tax law sunsets on December 1, 2026. It will be automatically repealed earlier if the federal limitation on state tax deductions is also repealed.
Windes Can Help
We advise taxpayers interested in this election to contact us to determine eligibility. Windes is a leading accounting firm providing a host of Audit, Tax, and Advisory services. Connect with us today to explore your options.