On July 16, 2021, California enacted A.B. 150, which included the “Small Business Relief Act” providing a pass-through entity (PTE) tax election for the years 2021-2025.
What is A.B. 150?
Assembly Bill 150 is a new California law that allows partnerships, S-corporations, and LLC’s to make an election to pay state income tax at the company level and deduct the expense against federal taxable income while generating a California credit the owners can use on their individual tax return.
Why make the election?
Individual owners of PTE’s can potentially realize significant federal tax savings by getting around the $10,000 state and local tax (SALT) deduction limit enacted in 2018.
Who does it apply to?
Election eligibility is limited to a “qualified entity.” A qualified entity must satisfy two requirements: (1) it must be an entity that is taxed as a partnership or S corporation, and (2) its partners, members, or shareholders must be exclusively individuals, fiduciaries, estates, trusts, or corporations (C or S corporations). As a result, a tiered partnership and disregarded entities (single-member LLC’s) are not qualified under the California PTE tax election rules. Further, a qualified entity does not include a publicly traded partnership or an entity that is permitted or required to be included in a combined reporting group. Thus, the qualified entity requirements could, in some rare instances, exclude S corporations and partnerships from eligibility to make the California PTE tax election.
How does it work?
The election allows the business owner to reduce federal adjusted gross income rather than having a state tax deduction on their individual tax return, which would be subject to the $10,000 (SALT) deduction limit. For federal purposes, the owner will reduce net income by the amount of the tax. For California, the tax will be added back into net income, but the owners will receive a California tax credit equal to the state tax paid by the pass-through entity on behalf of the owner.
A qualified entity may make an election to pay a PTE tax equal to 9.3% of its qualified net income. The irrevocable election is made annually and can only be made on an original, timely filed return.
The California PTE tax credit is not refundable. If the credit exceeds a qualified taxpayer’s net personal income tax, the excess is carried forward up to four years. It is unclear how any excess tax credit remaining will be treated.
The tax election is automatically repealed on December 31, 2026. If the federal $10,000 SALT limitation is repealed before December 31, 2026, the elective PTE tax will become inoperative following January 1.
Does this really work?
The IRS gave its “stamp of approval” to these types of pass-through entity taxes in IRS Notice 2020-75 and stated that they intend to issue proposed regulations clarifying the tax treatment of taxes on both the entity’s and owners’ returns.
An IRS notice is not law and therefore, significant uncertainty exists as to if these elections enacted at the state level will be challenged. However, states (including California) have swiftly begun passing legislation as the IRS has opened the door.
What does a business owner need to do?
It is still unclear for 2021, but starting with tax year 2022, and by June 15 of the taxable year of the election, the PTE must make a payment of 50% of the electing tax paid in the previous taxable year, or $1,000, whichever is greater. If the payment is not made, the PTE cannot make the election for that year. There is no such payment requirement for tax year 2021.
Notice 2020-75 appears to state that the PTE would deduct the tax in the year the tax is paid. This would mean that a tax payment made in 2022 for the 2021 tax year would be deducted on the PTE’s 2022 tax return and passed through on the 2022 K-1. We are waiting for more guidance from the FTB in regards to the process of making 2021 tax payments.
I have questions, how do I get answers?
B+Co professionals are available to assist you and discuss how this new legislation may impact you personally. Do not hesitate to contact your B+Co team members.