California passed Assembly Bill 150 (AB 150), which allows qualified S corporations, partnerships, or LLCs to pay tax on their individual, trust, or estate owners’ share of the entity’s qualified net income at the entity level. It also allows these owners to claim a credit for the tax paid on their California personal income tax return. This means you may reduce your federal taxable income by the amount of tax paid, and you may also qualify to claim a 100% California credit equal to the amount of the entity tax paid on your share of the entity’s income.
This tax treatment is commonly referred to as the state and local tax (SALT) workaround or PTE credit. The federal Tax Cuts and Jobs Act passed in 2017 reduced the amount of the SALT deduction individuals can claim on their federal tax return to $10,000 starting with the 2018 tax year.
AB 150 may offer relief because the taxes paid on your share of the pass-through income will not be counted toward your $10,000 state and local tax deduction limit. However, there are limitations related to California’s Tentative Minimum Tax that limit or eliminate this benefit for some taxpayers. Additionally, provisions in AB 150 indicate an elimination of the SALT limitation would negate the workaround opportunity.
For the 2021 through 2025 taxable years, a qualified S corporation, partnership, or LLC taxed as a partnership or S corporation that is doing business in California and is required to file a California return may make an election to pay the statutory rate of 9.3% of its “qualified net income”. This will decrease the federal net income included on the owners’ K-1.
“Qualified net income” is the sum of the pro-rata share, or distributive share, of income of the entity’s individual, trust, or estate owners subject to California taxation that consent to have their share of income subject to the passthrough entity elective tax.
Only entities taxed as an S corporation, partnership, or an LLC taxed as a partnership or an S corporation are eligible to make the election and only if: 1) The entity’s shareholders/partners are not partnerships and the entity is not permitted or allowed to be in a combined return and the entity is not a publicly traded partnership.
A “qualified taxpayer” is an individual, trust, or estate subject to California personal income tax that is a partner, shareholder, or member of an LLC treated as a partnership or S corporation that consented to have the entity pay tax on their pro-rata or distributive share of the entity’s income. A qualified taxpayer does not include a corporation or a business entity that is disregarded for federal tax purposes.
The election is made annually, is irrevocable, and is made on an original, timely filed return, including extensions.
The election could be beneficial, but there are a lot of factors to consider in evaluating whether it makes sense for you. Namely, the Build Back Better Act as currently drafted in the House of Representatives as of the date of this publishing makes changes to the SALT Limitation at the Federal level. This could limit or eliminate this benefit for some taxpayers if made retroactive back to the 2021 tax years. More guidance is needed to be certain how AB 150 will benefit each taxpayer. Additionally, the credit is not allowed to reduce California’s tentative minimum taxable income, which may limit the ability of taxpayers to realize the intended tax benefit.
Due to the number of open issues with respect to this opportunity, we caution taxpayers to evaluate the benefit and risk carefully. Moving into 2022, the opportunity should become more clear as additional guidance is provided by the IRS.