Numerous states have enacted a workaround to the state and local income tax deduction cap of $10,000, allowing certain pass-through entities to be taxed at the entity level for state taxes and then deducting tax payments at the federal level. The owner can benefit since the income distributed has already been reduced by the state tax expense.
Key insights
- AB 150 was passed on July 16, 2021, allowing qualified pass-through entities to make this election, which must be done annually on a timely filed return.
- Each member of the qualified entity must make the election separately.
- New tax legislation passed in February 2022 brought clarification to PTE eligibility and more.
We can help analyze whether this election makes sense for you and your entity.
At a glance: Newest updates to state tax workaround
With the passage of SB 113, the following changes are effective 2021:
- A qualified PTE now includes PTEs with partnership owners
- Federal disregarded entity owners of PTEs are now eligible taxpayers and can participate in the PTE election and claim a PTE credit
- Income taxed under the PTE election now includes guaranteed payments made to owners
- PTE credit can now be used to offset tentative alternative minimum tax
In addition, effective 2022, the PTE credit can be utilized against an individual’s California personal income tax liability after the credit for taxes paid to other states.
The Tax Cuts and Jobs Act (TCJA) passed in late 2017 put a limit on the amount of state taxes individuals could subtract as itemized deductions. Since that time, numerous states have enacted a workaround to the state and local income tax (SALT) deduction cap of $10,000 by allowing certain pass-through entities (PTEs) to be taxed at the entity level for state taxes. This allows PTEs, such as S corporations and partnerships, the ability to deduct their tax payments at the federal level as a business expense, essentially bypassing the SALT deduction limit at the owner level. This is especially beneficial to PTE owners who are limited by the $10,000 limit or are taking the standard deduction on their individual return.
On July 16, 2021, California Governor Gavin Newsom signed Assembly Bill 150, allowing this workaround for S corporations and partnerships for tax years beginning on or after January 1, 2021. On February 9, 2022, the Governor approved Senate Bill 113, which made favorable changes to the workaround tax legislation (generally, effective for 2021).
PTEs can elect to pay a 9.3% income tax as long as they are not part of a combined reporting group and are not publicly traded. With the passage of SB 113, PTEs with partnership or federal disregarded entity owners are now eligible owners. Owners of entities who pay personal income tax can claim a nonrefundable credit equal to the tax the entity pays. The workaround will be in effect through tax years beginning before January 1, 2026 to match the timing of the federal deduction limit law.
Election and credits
The election is irrevocable and must be made annually on the original timely filed return in the form and manner as prescribed by the Franchise Tax Board. Each owner within an eligible PTE can consent to have their share of income (including guaranteed payments) subject to the PTE tax. If an owner does not consent, it doesn’t preclude other owners from making the annual election to pay the tax. The tax paid will be computed based on the electing owner’s distributive share of pass-through income.
In the event the PTE credit allowed exceeds the net tax reported on the owner’s return, the excess will be carried forward to reduce the tax in the following taxable year, and any of the succeeding four years (for a total of five years). Previous legislation limited the credit to the regular tax. However, SB 113 allows the credit to reduce the tentative alternative minimum tax as well.
In accordance with SB 113, the PTE credit is now set in the ordering process to fall after the credit for taxes paid to other states starting with the 2022 tax year. This will likely be an issue for the 2021 tax year, as the ordering would be to use the PTE credit prior to using the credit for taxes paid to other states. While the PTE credit is allowed to be a carryover, the credit for taxes paid to other states is not.
Estimated tax payments
For tax years beginning on or after January 1, 2021, and before January 1, 2022, the PTE tax is due on or before the original due date of the return. For tax years beginning on or after January 1, 2022, and before January 1, 2026, the PTE tax is due in the following increments:
- The first installment is due on or before June 15 of the taxable year of the annual election, which is to be the greater of either 50% of the elective tax paid the prior taxable year or $1,000.
- The second installment is due on or before the due date of the original return for the qualified entity without regard to any extensions (March 15 for a calendar entity).
PTEs that have already made tax distributions to owners for first and second quarter estimated tax payments will likely be coming out of pocket twice to pay the tax, since the estimated tax paid at the individual level is not automatically applied against the PTE tax that is due.
How we can help
Determining whether or not to make this election can be complicated — based on where your entity is doing business and the location of the owners. Our state and local tax professionals can assist with questions on how the calculation works and whether or not this election could be beneficial for you. We’re here to know you and to help you.