Federal Deduction For State Income Taxes are Partially Restored
On July 16, 2021, California Governor Gavin Newsom signed into state law Assembly Bill 150 (“AB 150”), establishing a new pass-through entity (“PTE”) elective tax. The legislation enables California taxpayers who own PTEs to receive a credit for their share of the PTE-level state and local taxes deducted by partnerships and S-Corporations. In addition, the IRS has issued guidance under Notice 2020-75 approving this which removes any uncertainty.
Previously, and effective for tax years 2018 through 2025, the Tax Cuts and Jobs Act of 2017 added IRC Section 164(b)(6) limiting the individual federal deduction for state and local taxes to $10,000 ($5,000 for married filing separate). AB 150 provides a workaround to the deduction limitation for owners of PTEs, and effective for tax years 2021 through 2025.
The PTE tax is 9.3% of qualified net income, which is the distributive share of income subject to California personal income tax of qualified taxpayers. Details on entity eligibility, election and payment requirements, owner taxation, and other considerations are summarized below.
- Doing business in California and are required to file a California tax return.
- Taxed as a partnership or S-Corporation.
- Has elected to pay the PTE tax and make payments by the required due dates.
- Has owners that are exclusively corporations or qualified taxpayers (qualified taxpayers include individuals, fiduciaries, estates, and trusts).
- Does not include owners that are other partnerships. So, for example, if you have a partnership or LLC with a member that is a partnership, the entire entity, and all partners or members are not eligible.
- Publicly traded partnerships, or entities required to be included in a California combined reporting group are not qualified.
Election and PTE Tax Payment Requirements
- Requires an annual election on an original, timely filed return.
- Once made, the election is irrevocable for that year and is binding on all consenting owners of the PTE.
- PTE tax is paid at the entity level and included as a credit on the qualified taxpayer’s Schedule K-1 and will be claimed on the individual’s income tax return as a credit for tax paid.
- PTE tax is in addition to any other required personal or corporate income tax.
- For tax year 2021, PTE tax is due on the due date without regard to extensions, which is March 15, 2022 for a calendar year taxpayer. However, to get the deduction in 2021 you would want to pay it before year-end.
- For tax years 2022 through 2025, PTE tax must be made in 2 payments with the first due by June 15th of the taxable year, and the remainder due by the original due date of the PTE return without regard to extensions:
- The June 15th payment amount is 50% of the PTE tax paid in the prior year or $1,000, whichever is greater.
- If no payment is made by the June 15th payment deadline, the qualifying entity may not make the PTE election for that taxable year.
- As previously mentioned, the PTE tax is a flat 9.3% of qualified net income.
- For California residents, the full amount of distributive income is included in the PTE tax base.
- For nonresidents, the California source portion of distributive income is included in the PTE tax base.
- The distributive income of corporations and disregarded entities (including their owners) are not included in the PTE tax base.
- Qualified taxpayers may claim a nonrefundable credit to offset their California individual income taxes equal to 9.3% of the qualified taxpayer’s qualified net income subject to the PTE tax.
- Any PTE tax credit exceeding the qualified taxpayer’s current year California income tax may be carried forward up to 5 succeeding years.
- Partnership or S-Corporations eligible to be considered as an electing qualifying entity should consider whether making the election and paying the elective tax on or before the end of 2021 would help maximize the qualified taxpayer’s federal deduction for state and local taxes for 2021.
- Eligible entities should consider whether highly compensated California employees may benefit by restructuring their wages to a reasonable and acceptable level as pass-through entity income and electing the California PTE tax.
- AB 150 is effective through the 2025 tax year to coincide with the expiration of the federal state and local tax deduction limitation included under IRC Section 164(b)(6): If the federal limitation is repealed prior to its planned expiration, AB 180 will become inoperative by the following January 1st.
- Make sure to reduce planned estimated CA tax payments and pay them instead of through the pass-through entity. Please consult with us asap.
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To illustrate. Assume that you earn $500,000 as your share from a partnership or S-Corporation that is a qualified entity. You make the election and pay 9.3% of your earnings to the State from the pass-through entity, which calculates to $46,500. Therefore, your share of the income for federal tax purposes would be reduced to $500,000 less $46,500, or $453,500 that you would be taxed on, and you will get credit on your personal return for the $46,500 paid. In essence, the deduction for state income taxes is now partially restored.
If you have any questions about the California pass-through entity tax and how it may impact you or your business, please do not hesitate to reach out to us for assistance.