California Makes Significant Changes to PTE Tax and Repeals 2022 NOL Credit Limits
On February 9, 2022, Senate Bill 113 (SB 113) was signed into law by Governor Newsom. This bill changes California tax law significantly as well as includes the reinstatement of the Business Tax Credit. This bill also includes net operating loss (NOL) deduction and the expansion of California’s pass-through unit (PTE) tax. Changes that are effective for the tax years beginning on or after January 1, 2021, include:
- Allowing the pass-through entity tax credit to reduce the net income tax below the tentative minimum tax.
- Guaranteed payments to consenting qualified taxpayers in the qualified entity tax base for purposes of computing the pass-through entity tax.
- Single member limited liability companies (“SMLLCs”) owned by individuals, estates, or trusts in the definition of a qualified taxpayer (allowing these SMLLCs to consent and for their owners to receive a pass-through entity tax credit).
- Entities that have partnerships as partners in the definition of a qualified entity, allowing them to make the pass-through entity tax election. However, partnerships are not qualified taxpayers, which means their income is not included in the pass-through entity tax base and the partnership does not receive a pass-through entity tax credit.
Changes that are effective in tax years beginning or after January 1, 2022 are:
- Re-orders credit usage to allow for use of other state tax credits before the pass-through entity tax credit for tax years beginning on or after January 1, 2022, and before January 1, 2026.
- Eliminates the $5 million business credit limit for tax years beginning on or after January 1, 2022.
- Removes the net operating suspension for tax years beginning on or after January 1, 2022.
NOL Deduction and Restoration of Tax Credit
Currently, the NOL suspension applies to California taxpayers with a net business income of $1 million or more. The number of business tax credits that could be used in a year was limited to $5 million for the tax years 2020, 2021, and 2022. With SB 113, NOLs are restored and the limit on business tax credits for the 2022 tax year has been removed, effectively shortening the longer suspension period for NOL deductions and use of tax credits under SB 85. These business tax credits include the R&D credit, The California compete credit, and insurance tax credit.
Extension of Optional PTE Tax
SB 113 also modifies the state’s elective PTE tax law. Unless otherwise noted, the changes to the elective PTE tax law apply to tax years beginning on or after January 1, 2021, and before January 1, 2026. The changes include:
- Amending the definition of “qualified entity” to include a partnership as an eligible partner, shareholder, or member
- Including guaranteed payments defined by IRC Section 707(c) as qualified net income so they qualify for the credit
- Removing a provision that prohibits the credit for PTE tax paid from reducing the tax owed below a taxpayer’s tentative minimum tax, effective for tax years beginning on or after January 1, 2021
- Requiring the elective tax credit to be applied against the net tax after credits for taxes paid to other states, effective for tax years beginning on or after January 1, 2022
- Allowing a business owned by individuals using a limited liability company that is disregarded for federal income tax purposes and meets certain conditions to elect the PTE tax and credit
With these changes, the allowance of pass-through entities with partnerships and/or disregarded entities as partners to elect to pay the PTE tax will significantly expand the population of businesses that were not previously eligible and may eliminate the need to restructure business operations to create an eligible entity and/or taxpayer. Businesses that previously were ineligible may want to consider making an election for the 2021 tax year. The election must be made on a timely filed tax return, which includes extensions of time to file, and payment must be made on or before March 15, 2022. For cash-basis entities and accrual-based entities that did not have a fixed and determinable liability at their year-end, there may be a mismatch between the year in which the tax is deducted for federal income tax purposes and the year in which the credit is claimed on the California tax return.
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