The Franchise Tax Board (“FTB”) has recently provided additional information and clarification on several important issues which we have summarized below on top of our last guidance dated 12/07/2021:
- Underpayment or overpayment of CA PTET – The full 9.3% must be paid on all qualified income by the original due date of the tax return (March 15, 2022 for calendar-year taxpayers, or within 2.5 months after year-end for fiscal-year taxpayers). Underpayments will be subject to penalties and interest and unpaid tax if filed after the original due date. Entities that overpay the CA PTET will be entitled to refunds at the entity level. This means that if you paid a payment based on an estimate before year end and you either underpaid or overpaid additional amounts must be paid, or you will be entitled to a refund.
- Calculation of the CA PTET – The tax is equal to 9.3% of the entity’s qualified net income, which is the distributive share of income for all consenting owners. For S corporation shareholders, the distributive share of income can be computed by taking the sum of lines 1-10 minus lines 11 and 12 from the K-1 (100S). For partners in partnerships, the distributive share of income can be computed by taking the sum of lines 1-3 and lines 5-11 minus lines 12 and 13 from the K-1 (565/568).
- Application of CA PTET and estimated taxes – The FTB has confirmed that the CA PTET credit will be applied to reduce tax liabilities before estimated tax payments will apply.
- CA PTET and E-Pay requirements – Payment of the CA PTET is made by the entity and therefore will not trigger e-pay requirements for the owners. Partnerships and LLCs are not subject to the e-pay requirements. For S-Corporations, the mandatory e-pay requirements will be triggered if the final tax liability, including CA PTET, is over $80,000 when the return is filed. S-Corporations subject to the mandate will be required to make all future payments electronically.
- CA PTET for trusts and beneficiaries – The FTB has confirmed that trusts, including grantor trusts and intentionally defective grantor trusts, are qualified taxpayers eligible to claim the credit. The credit can be applied to the trust level tax or passed through to the beneficiary and will be reported on the 541 K-1 on line 13d, Other Credits.
- Credit order of application – Under California law, credits are taken in the following order:
- Credits that do not contain carryover or refundable provisions, except the Minimum Tax Credit or those that are allowed to reduce the net tax below the tentative minimum tax (described in #4 and #5 below);
- Credits that contain carryover provisions but do not contain refundable provisions (e.g., the Passthrough Entity Elective Tax Credit and the Main Street Small Business Hiring Credit), except for those that are allowed to reduce “net tax” below the tentative minimum tax;
- Credits that contain both carryover and refundable provisions;
- The minimum tax credit;
- Credits that are allowed to reduce “net tax” below the tentative minimum tax, such as the Research Credit;
- Other state tax credits; and
- Credits that contain refundable provisions but do not contain carryover provisions.
The FTB has confirmed that a California resident may also claim the Other State Tax Credit (“OSTC”) for passthrough entity elective taxes paid to other states. Per the above order of application, CA PTET is applied before the OSTC, however, the OSTC can also apply against TMT, as provided in the following example.
Example for Other State Tax Credit – A CA resident taxpayer receives PTET credits for CA of $50,000 and NY of $20,000 (this example assumes that the NY credit is equal to or less than the NY tax liability). The total CA tax is $100,000, which includes $70,000 of TMT. Accordingly, the CA PTET can be applied up to TMT, leaving $20,000 carried forward ($100,000 total tax less $70,000 TMT = $30,000; $50,000 CA PTET less $30,000 = $20,000). The NY PTET is subsequently applied to the remaining tax for a remaining tax liability of $50,000 ($70,000 TMT less $20,000 NY PTET = $50,000).
- CA PTET on capital gain income – It is still unclear if CA PTET paid on capital gain income will be allowed as a deduction to arrive at adjusted gross income, aka an “above-the-line” deduction. It is possible that there will be no above-the-line deduction for CA PTET on capital gain income allowed on the federal tax return. We will provide guidance on this when available
Original guidance dated 12/07/2021
The recently enacted Assembly Bill 150, which established the California Pass-Through Entity Tax Credit (“CA PTET”), currently includes some limitations on the use of the credit that greatly reduces the possible benefits of making the election. For information on who qualifies for the CA PTET, you can view our initial memo here.
As clarified by the Franchise Tax Board, the CA PTET does not reduce the amount of state tax due below the tentative minimum tax (“TMT”). The California TMT is calculated as California adjusted taxable income, plus or minus preference items, less the exemption amount, and multiplied by 7%. Accordingly, the CA PTET will not reduce state tax below the 7% TMT even if the taxpayer is not required to pay alternative minimum tax.
California taxpayers with an effective tax rate below the 7% TMT will not receive any benefit from the CA PTET. The credit is non-refundable and any excess credit may be carried forward only five years.
California taxpayers with an effective tax rate above the 7% TMT may only receive partial benefit from the CA PTET, which will depend on the amount of income from pass-through entities and all other sources. To illustrate this limitation, we’ll use the following examples (for simplicity we are ignoring progressive rates, mental health tax, itemized deductions, and other exemptions):
- Example A – an individual taxpayer with $1 million of distributive net income from a pass-through entity and no other income will receive a CA PTET credit of $93,000 ($1M x 9.3% CA PTET rate). The regular tax liability is $123,000 ($1M x 12.3% tax rate) and the TMT is $70,000 ($1M x 7% tax rate). The taxpayer can only use $53,000 of the CA PTET ($123,000 tax less $70,000 TMT) with the remaining $40,000 carried forward to next year.
- Example B – the facts are the same as in Example A, except the taxpayer has non-pass-through entity income of an additional $1 million for a total of $2 million taxable income. The CA PTET credit is $93,000 ($1M x 9.3% CA PTET rate). The regular tax liability is $246,000 ($2M x 12.3% tax rate) and the TMT is $140,000 ($2M x 7% tax rate). The taxpayer can use the full $93,000 of the CA PTET in the current tax year ($246,000 tax less $140,000 TMT = $106,000 > $93,000).
In each of the above examples, the federal taxable pass-through income is reduced by the CA PTET if paid before the end of the taxable year, thereby generating additional federal tax savings at the owner level for partnerships and S Corporations.
Exception to the CA TMT: When a California taxpayer’s gross business receipts from all sources combined are less than $1 million, the net business income is not subject to the 7% TMT. In this scenario, only the non-business income will be subject to the 7% TMT and the taxpayer may be able to utilize the CA PTET credit in full. The $1 million limit for this exception is the same for both single and married-filing-joint taxpayers. The $1 million limit is a cliff, meaning it does not have a phase out range.
- Example C – a taxpayer is the sole shareholder of an S corporation. She has $100,000 of W-2 income. The taxpayer’s share of gross receipts from the S corporation is $950,000, the net pass-through income is $250,000 for CA purposes, and the CA PTET is 9.3% of the pass-through income, or $23,250. Because the taxpayer’s share of business gross receipts is less than $1 million, the $250,000 of business net income is not subject to the CA TMT. The total CA tax on $350,000 of total income is approximately $30,000. The TMT is 7% of the $100,000 of wages, which is $7,000. Only $23,000 ($30,000 – $7,000) of the CA tax can be offset by the PTET credit. $23,000 of the PTET Credit is utilized, $7,000 is the CA tax owed, and $250 of PTET Credit is carried forward up to 5 years. The federal taxable pass-through income from the S-corp is reduced by the $23,250 PTET if it was paid by the S-Corp by December 31, saving the taxpayer approximately $8,000 in federal tax.
For S Corporations with multiple shareholders making the election, further consideration should be made on any impact the CA PTET will have on shareholder distributions. S Corporations could potentially violate their S-election if all shareholders do not consent to making the election, and possibly resulting in disproportionate distributions.
Furthermore, another possible limitation of the CA PTET relates to nonresidents. There is currently no provision to reduce the nonresident withholding requirements on electing qualified entities below the required 7% TMT, which may again lead to excess credit carryover.
Careful tax planning should be performed with respect to which pass-through entities and owners make or consent to the election and the impact of the TMT on the CA PTET at the owner level. Once made, the election is irrevocable for that year and is binding on all consenting owners.
The number of eligible entities, amount of distributive net income, sources of other income and any other factors should all be considered for the effective use of the CA PTET election. Additionally, should the current version of the Build Back Better Act pass, the state and local tax deduction cap will increase from $10,000 to $80,000 retroactive to the 2021 tax year, further diminishing the benefit of the CA PTET workaround to the deduction limitation for owners of pass-through entities.
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.