California has joined the ranks of states who have developed a way to circumvent the $10,000 federal deduction limitation state and local taxes (known as SALT) limitation with the enactment of A.B.150 recently signed by Governor Gavin Newsom. Effective for tax years 2021-2025, the Small Business Relief Act provisions of A.B. 150 allow passthrough entities – including partnerships, limited partnerships, LLCs and S Corporations – to get around the $10,000 limitation on SALT by permitting them to pay tax on its income at a 9.3% rate, which is then taken as a deduction on the entity’s federal income taxes and treated as a credit on the owner’s California income tax return.
By creating an elective tax that an entity pays on behalf of owners, this new passthrough level tax bypasses the $10,000 annual federal state and local income tax limitation – allowing entities to deduct the full amount of tax and local payments on federal taxes. Any business owner owing more than $10,000 in California tax should look seriously at this new alternative passthrough entity tax.
The passthrough entity tax is an irrevocable election made annually by one of the following entities:
1. General or Limited Partnership including a Limited Liability Partnership;
2. Limited Liability Company; or
3. S Corporation.
It does not include the following:
1. Trust unless taxed as a partnership;
2. Publicly traded partnership;
3. Sole Proprietorship;
4. Single member LLC;
5. Entity that is permitted or required to be part of a combined reporting group; or
6. Entity with a passthrough owner like a partnership or LLC.
Eligible passthrough entity owners include the following:
3. Estates; or
4. C corporations.
For 2021, the election to pay the passthrough entity tax is made and the tax is due on the due date of the passthrough entity’s tax return (March 15, 2022 for tax years 2021). Beginning in 2022, the tax is paid in 2 installments, on June 15th of the greater of 50% of the tax paid in the prior taxable year or $1,000 and the balance is due on or before the original due date of the passthrough entity’s California income tax return (normally March 15th).
As discussed earlier, the passthrough entity takes a tax deduction for the tax paid or accrued (depending on its accounting method) and the owners get a nonrefundable California tax credit for the owner’s share of the tax paid. Excess tax credits can be carried forward up to 5 years. The tax is only paid on the income attributable to a consenting owner. If an owner doesn’t consent, it does not prevent the passthrough entity making an election to pay tax on the income of another consenting owner. If the federal SALT cap does go away, then the new passthrough entity tax and credit also are repealed.
The provision allowing for this new passthrough entity tax is very brief and the administration of the tax is left to the Franchise Tax Board. Many businesses may want to include the election to pay the passthrough entity tax included in the entity’s partnership agreement, operating agreement, LLC agreement or shareholders agreement. In addition, obtaining an annual consent from each owner and anyone with the community property interest is also a good practice.
Author: Phil Jelsma, Crosbie Gliner Schiffman Southard & Swanson (CGS3), firstname.lastname@example.org.