On July 16, 2021, California Governor Gavin Newsom signed into law Assembly Bill (AB) 150, the Small Business Relief Act.
This Act allows limited liability companies (LLC), S corporations, and partnerships—also known as pass-through entities (PTE)—the opportunity to claim a state income tax deduction on their federal income tax return for taxes paid to California.
Understanding the New Law
Currently, the Internal Revenue Code (IRC) places significant limitations on state tax deductions for individuals. California’s new law provides a workaround to this limitation by allowing a PTE to make an election to pay California income tax at the entity level.
Specifically, the election creates a deduction on the PTE’s federal income tax return because the state taxes paid by the PTE reduce the federal taxable income that its electing owners report on their federal income tax return. An electing taxpayer receives a California tax credit for the tax paid at the entity level, which can offset their California individual income tax obligation.
If this election is made, qualified PTEs calculate the entity-level tax using a fixed tax rate of 9.3%. Taxpayers subject to higher income tax rates—California’s highest personal income tax rate is currently 13.3%—will need to pay any additional tax due with their individual return.
Defining Qualified Entities
AB 150 allows only a qualified entity to elect to pay income tax on the entity’s net income for the taxable year. A qualified entity is an entity taxed as a partnership or S corporation. Therefore, a general partnership, limited partnership, or LLC that’s taxed as a partnership could be a qualified entity while a publicly traded partnership can’t be a qualified entity.
Additionally, a qualified entity can only be owned by corporations, fiduciaries, estates, trusts, or individuals. Therefore, a PTE isn’t a qualified entity if its ownership group includes a disregarded entity, a partnership, or a corporation that’s a member of a combined reporting group or eligible as a member of a combined report for corporate tax.
As a result of these limitations, a careful review with a tax advisor of the PTE’s organization structure, including the composition of its ownership group, is recommended. For example, where a legal entity structure includes tiered partnerships or disregarded entities, additional organizational planning will likely be required for those entities wanting to participate in this opportunity.
Defining Qualified Taxpayers
AB 150 allows only qualified taxpayers to claim a federal income tax deduction for the tax paid by the PTE. California defines a qualified taxpayer as a partner, shareholder, or member of an electing qualified entity that consents to have its income subject to this tax. A qualified taxpayer excludes partnerships and business entities that are disregarded for federal tax purposes, including the disregarded entity’s partners or members.
Therefore, even though an S corporation can own a qualified entity, it can’t claim the tax deduction. Instead, the state income tax deduction is claimed by an electing taxpayer, such as individuals, estates, or trusts—regardless of their state of residence.
Elective Tax Due Dates
Entities are eligible to participate for taxable years beginning on or after January 1, 2021, and before January 1, 2026. Entities interested in participating in 2021 will have to pay the full measure of tax on or before the due date of the original return, without regard to any extension.
For entities interested in participating between January 1, 2022, and January 1, 2026, the requirements are slightly different. On or before June 15 of the electing tax year, at least 50% of the elective tax must be paid. Thereafter, the remainder of the tax is due by the original date of the return, without regard to any extension.
It’s unclear at this time what happens if an unexpected income event occurs in the second half of the year.
Entities interested in participating in this program will need to begin tax planning for the current year with consideration taken for their eligibility and the benefits of the election.
Election Requirements
California requires that a qualifying entity make the election on an original, timely filed return for the tax year.
Once the election is made, it’s irrevocable for the tax year. Under the election, the qualifying entity may include any partners, members, or shareholders who consent to the election.
Partners, members, and shareholders who skip the election don’t prevent the qualified entity from making the election to pay the elective tax for members who choose to participate in the opportunity.
As the election allows for both consenting and nonconsenting partners, members, and shareholders, planning will likely be necessary to determine tax amounts and impacts on the entity-level income for the qualifying entity, in coordination with other estimated tax payments, withholding, and other filing requirements.
California Income Tax Deduction
AB 150 calculates the tax to be paid by a qualified entity by multiplying the entity’s qualified net income by a tax rate of 9.3%. The entity’s qualified net income is the sum of the pro rata or distributive shares of income for any of the entity’s qualified taxpayers. This elective tax is in addition to, and not in place of, any other tax or fee that applies to the entity, such as:
- LLC fees and taxes
- S corporation’s 1.5% California tax rate
Setting the tax rate at 9.3% will likely necessitate planning for individuals whose income is potentially subject to higher personal income tax rates, including the mental health services tax, for the taxable year.
Claiming the Credit in California
A qualified taxpayer can claim a credit on their California tax return equal to the tax paid by the qualified entity on their distributive share of income, gain, loss, and expense subject to tax in California.
If the credit exceeds the tax owed by the individual, the credit can be carried forward for up to five years. The credit isn’t refundable.
Qualified taxpayers may face limitations on the use of the California credits, including ordering rules for other credits and credits for taxes paid to other states. As a result, consideration should be given to usage of the credit within the five-year carryforward period.
Forthcoming Regulations
The California legislature has directed the Franchise Tax Board to publish regulations and procedures for making the election.
Next Steps
Any taxpayers interested in this election should contact their tax advisor to explore whether this election is right for them.
With the overlap of federal income tax laws and AB 150, additional analysis and modeling is recommended to assess the available state income tax deduction for the electing entity as well as the potential value for the qualified taxpayer.
A taxpayer’s current legal structure also may not accommodate this election. A taxpayer interested in this election will want to carefully analyze whether changing its business structure is necessary to claim the elective credit for state taxes paid.
We’re Here to Help
To learn more about how California’s PTE elective tax may affect your business, contact your Moss Adams professional.