Fernway DiarySM

Jun 21, 2022

When the Tax Cuts and Jobs Act (TCJA) was passed in late 2017, it imposed a significant change in the ability of individual taxpayers who itemize their deductions to claim a federal income tax deduction for state and local income taxes (SALT). Prior to that legislation, SALT payments made during the calendar year could be deducted up to the extent of the taxpayer’s federal taxable income. The TCJA capped this deduction at $10,000 annually, affecting certain taxpayers from high-tax states such as California and New York, who could no longer claim the full amount of their property and state income taxes as federal tax deductions. (Currently this limit is set to expire after 2025 if Congress does not extend it.)

Several states have looked for ways to protect residents from a potential increase in their federal tax liabilities due to the cap on SALT deductions. As one means of doing so, 22 states have enacted some form of a pass-through entity (PTE) tax as of February 2022, after the IRS signaled in November 2020 that it would allow a PTE deduction in future regulations via Notice 2020-75. This allows a qualified pass-through entity to pay certain state and local income taxes directly. Those payments made by a partnership or S corporation are generally allowed as a federal entity-level deduction in computing non-separately stated taxable income or loss for the year of payment, but are generally excluded when applying the SALT limitation to individual partners, members, or shareholders of pass-through entities, even though the PTE tax payments are creditable against their respective individual state income tax liabilities. Thus, consenting partners, members, or shareholders are likely able to claim a nonrefundable credit on their personal income tax return proportionate to the elective tax paid on their behalf.

California, amongst other states, has established its elective pass-through entity tax, which is effective for tax years beginning after January 1, 2021, and before January 1, 2026, for qualified entities required to file a California return, in July 2021 with AB150, and updated it with technical corrections in February 2022 through SB 113.

How California’s PTE Tax Works

In California, qualified entities can make an election on an annual basis to pay a 9.3 tax on their qualified net income. If the entity chooses to participate, individual owners may choose to have the entity pay tax on their share of the entity’s taxable income; nonconsenting owners generally do not disqualify an entity from making such election. The election is irrevocable and should generally be made on a timely filed tax return for the year of election. For tax years beginning on or after January 1, 2022, an amount equal to the greater of $1,000 or 50 of the elective tax paid in the prior taxable year is generally due on or before June 15^th, with the balance of tax due on or before the due date of the original tax return, without regard to any extension of time to file.

Qualified entities: Entities that are taxed as a partnership or S corporation and which have owners consisting solely of individuals, partnerships, corporations, fiduciaries, trusts, or estates. This includes LLCs that have elected to be taxed as a partnership or S corporation. Publicly traded partnerships and entities permitted or required to file a combined tax return generally do not qualify.

Qualified taxpayer: Any individual, fiduciary, estate, or trust subject to California personal income tax that consents to have their pro rata share or distributive share of income taxed at the PTE level.

Tax base: Qualified net income is the sum of the pro rata or distributive share of all qualified taxpayers subject to California personal income tax. This includes the full amount of consenting California residents’ distributive share of income and the California-sourced portion of consenting nonresidents’ share of income.

Credit: Consenting owners are generally allowed a credit for the 9.3 proportionate tax paid on their distributive share of income. While the PTE tax credit is generally not refundable, it may be carried forward for up to 5 years.

Changes Introduced by SB 113

SB 113 made certain changes to California’s PTE tax intended to better benefit qualifying taxpayers. This included amending the definition of “qualified entity” to include PTEs that have partnerships as owners; amending the definition of “qualified taxpayer” to include single-member LLCs owned by an individual, estate, or trust; and allowing PTE credits to reduce an individual’s regular tax below the tentative minimum tax (7). Whether an entity qualifies for a PTE election, or if an individual taxpayer may benefit from such election, is best assessed with the assistance of an expert tax professional, since the corresponding regulations and compliance requirements are complex, and an accurate determination generally requires further analysis of the taxpayer’s particular tax situation.

For more information, please contact your US tax advisory team at youradvisor@fernwaysolutions.com or visit us at www.fernwaysolutions.com.

Disclaimer:

The above content is intended to support the marketing of professional services and should not be construed as written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular tax situation. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with, or attached to this content is not intended to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Fernway Solutions assumes no obligation to inform the reader of any such changes.