Important Changes to California’s Elective Pass-Through Entity Tax
California recently revised its SALT cap workaround to be more appealing for qualifying owners of S corporations and partnerships.
On February 9, California’s governor signed into law Senate Bill 113 (S.B. 113), which modified certain technical aspects of the elective pass-through entity tax enacted in Assembly Bill 150 (A.B. 150) in July 2021. A number of the original limitations and rules surrounding these elective tax payments were removed, significantly increasing the tax benefit to qualified taxpayers and expanding the application of this benefit to more taxpayers.
As described in our year-end tax planning article, the SALT cap workaround allows S corporations and partnerships to elect to pay a 9.3% tax on taxable income at the entity level to reduce the amount of federal taxable income passed through to each of the owners. Since the entity is not subject to the Tax Cuts and Jobs Act’s $10,000 SALT cap, it can deduct a much higher amount than individuals can on a personal return.
This does not reduce CA taxable income; however, owners can claim a 100% state tax credit on their California income tax return of their portion of the tax paid by the entity, which would be used to reduce their state tax liability and to avoid being taxed on the same income twice.
Effective retroactively for tax years beginning on or after January 1, 2021, the following outlines the improved provisions in S.B. 113:
- Allows the pass-through entity credit to reduce the net income tax below the tentative minimum tax.
- Includes guaranteed payments to be included in the pass-through entity tax base of a qualified taxpayer.
- Allows a qualified entity to have partnerships as partners; however, please note that partnerships are not considered qualified taxpayers, meaning that their income will not be included in the tax base and will not receive a tax credit.
- Expands the definition of a “qualified taxpayer” to allow owners of single member limited liability companies to be included in the tax base.
Effective for tax years beginning on or after January 1, 2022, S.B. 113:
- Updates tax credit ordering rules to allow for the use of other state tax credits before the pass-through entity tax credit.
Individuals, estates, and trusts are eligible to receive this credit; however, any unused credit is still limited to the five-year carry forward period. The election to pay this tax through the pass-through entity is an annual election and should be considered each year the entity is eligible.
Keep in mind: the elective tax needs to be paid on a timely-filed tax return, without regard to any extensions. For taxable years after January 1, 2022 and before January 1, 2026, there are two payments required: the first is due on or before June 15th of the elective year, and the second will be due on or before the due date of the original return.
S.B. 113’s taxpayer-friendly provisions are an encouraging highpoint as businesses emerge from two challenging years as a result of the pandemic.
If you are an owner of an S corporation or partnership, we encourage you to discuss paying the elective pass-through entity tax with your advisor to determine whether it makes sense for you and your business.
You can still make this election for 2021 provided the qualifying entity pays the tax prior to March 15, 2022. Note that if you have already paid 100% of your 2021 CA tax through estimated payments, this may create a substantial overpayment. An overpayment will be available as a refund or applied to 2022 estimated taxes. Considering the federal benefit versus these cash flow implications are critical.
At the time of this article, the California forms are still being finalized with these changes, and we anticipate further technical guidance on how to implement the expanded benefits.
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