Since the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, individuals who itemize their federal tax deductions have been limited to a $10,000 deduction for state and local income taxes (“state taxes”). This has impacted taxpayers in high tax states such as California, New Jersey, and New York.
A pass-through entity (“PTE”) tax is meant to be a workaround for the federal $10,000 state tax limitation. It imposes an income tax directly on the PTE that is available as a non-refundable credit on the individual’s state tax return. The validity of a PTE tax has been the subject of scrutiny by the IRS, which left many states hesitant to adopt such a tax. In November 2020 the IRS issued Notice 2020-75, which announced the IRS’ intent to allow the PTE deduction in future regulations, validating the PTE strategy to avoid the federal $10,000 state tax limitation.
On July 16, 2021, California joined the ranks of 13 other states that have PTE taxes when Governor Gavin Newsom signed California Assembly Bill 150 (“CA AB150”). While California is the most recent state to pass such legislation, various other states currently have PTE tax bills pending, with most expected to be adopted.
How does CA’s PTE tax work?
For tax years beginning on or after January 1, 2021 and before January 1, 2026; qualified entities can make an irrevocable annual election to pay a 9.3% tax on the sum of each qualified taxpayer’s share of the PTE net income for the elected tax year.
Through the PTE’s payment of the elective tax, each qualified taxpayer will be allowed a nonrefundable credit against their CA income tax liability – which can be carried forward for up to five years if the credit exceeds the taxpayer’s CA tax liability in the year of the election.
What entities qualify for CA’s PTE tax?
Qualified entities must be doing business in CA and taxed as a partnership or S corporation. This includes limited liability companies that have elected to be taxed as a partnership or S corporation.
Sole proprietorships, PTEs that have a partnership owner, publicly traded partnerships, and entities required to be in a combined reporting group do not qualify for CA’s PTE tax.
Who are qualified taxpayers for CA’s PTE tax?
Qualified taxpayers include any individual, fiduciary, estate, or trust subject to CA’s personal income tax that consent to have their pro rata share or distributive share of income taxed at the PTE level.
It should be noted that a PTE with non-consenting owners do not limit the PTE’s ability to make CA’s PTE tax election.
How do qualified entities pay CA’s PTE tax?
For tax years beginning on or after January 1, 2021, and before January 1, 2022, CA’s PTE tax is due on or before the due date of the return without regard to any extensions. For calendar year filers, the 2021 tax year deadline is March 15, 2022.
For tax years beginning on or after January 1, 2022, and before January 1, 2026, the PTE tax is required to be paid in two installments. The first installment is due on or before June 15th of the current tax year and is the greater of $1,000 or 50% of the elective tax paid in prior year. The second installment is due on or before the due date of the return without regard to any extensions.
Regarding the above deadlines, the PTE election may be deemed invalid if the elective tax liability is not paid timely.
Qualified entities and their owners will need to evaluate the tax implications of making this election on a yearly basis. Ample time should be provided to evaluate the election’s benefits and obtain consent from eligible taxpayers. The current recommendation is that both the qualified entity and qualified taxpayer sign a written consent for each appliable year the PTE tax election is made.
As is common with new tax laws, there is still much that needs clarification so we eagerly await the regulations and/or guidance the Franchise Tax Board will release in the coming months.
In the meantime, we recommend working with a state and local tax expert to determine if your business should make the PTE election, and what owners should consent to the election. Get in touch with our state tax team today to get started.