SALT Cap Bypass with California Pass-Through Credit
Since its approval in July 2021, much information has been written about the California Pass-Through Entity Tax Credit. The California Small Business Relief Act established the PTE tax credit largely in reaction to the $10,000 limit on the amount that individual filers could deduct in state taxes on their federal tax returns as a result of the 2017 Tax Cuts and Jobs Act.
For instance, a taxpayer earning $200,000 in a state with a 10% tax rate incurs a $20,000 state tax, but only $10,000 of that amount is potentially deductible on their Form 1040. The $10,000 SALT deduction limitation includes all state, local, real, and personal property taxes. To offset this limitation, the legislature of California and 26 other states sought a workaround, and the result was the PTE, pass-through entities.
What is the PTE all about? The California Franchise Tax Board states that for taxable years beginning on or after Jan. 1, 2021, and before Jan. 1, 2026, qualifying PTEs, which are usually private partnerships or S corporations, may annually elect to pay an entity-level state tax on behalf of its members. The elective tax is 9.3% of the entity’s qualified net income. Eligible taxpayers receive a credit for their share of the entity-level tax, reducing their California personal income tax; any unused credits can be carried over for up to five years. The FTB specifies that a qualified taxpayer is a partner, member, or shareholder of an electing qualified entity that is:
- An individual, fiduciary, estate, or trust subject to California personal income tax; or,
- A disregarded single-member LLC owned by an individual, fiduciary, estate, or trust subject to California personal income tax.
A taxpayer must consent to have their pro rata or distributive share and guaranteed payments included in the qualified net income of the electing qualified PTE. An annual election is made on an original, timely filed tax return. Once the election is made, it is irrevocable for that year and is binding on all partners, shareholders, and members of the PTE.
In February 2022, the California State Senate made changes to the PTE tax and tax credit using Senate Bill 113. These changes include:
- PTE credits reduce net tax below a taxpayer’s tentative minimum tax;
- Qualified partnerships can have partners who are partnerships;
- Qualified taxpayers can include certain single-members LLCs;
- Qualified net income includes guaranteed payments; and,
- Other state tax credits will be used before the PTE tax credits.
What should filers and tax preparers be aware of? The law has only been on the books for one tax season. With the 2022 filing year upon us, California entities, owners, and their preparers must recognize the many issues affecting their PTE tax credit. If a pass-through entity has nonresident shareholders, members, or partners, the credit is applicable only for the California-sourced income. Additionally, S corporations must be cautious when making the election for qualified owners. Compensating distributions must be made to non-qualified shareholders to avoid jeopardizing the entity’s S corporation status.
The PTE’s timely filing is critical, as the pass-through entity must make minimum estimated tax payments on or before June 15, 2022, and each succeeding year through 2026. For California only, each qualified taxpayer is entitled to a nonrefundable credit that can be carried forward for up to five years or until used up. It is crucial that whoever oversees financial reporting for the entity should ensure that all the owners are aware of their elections and the amount paid on their behalf.
What can we expect going forward? For 2022 and subsequent years, the PTE elections must be made in a timely manner, and any overpayment that results in a refund needs to be applied to that year’s estimated tax payment. Thus, ample time should be provided to evaluate the election’s benefits and to obtain consent from eligible taxpayers.
Talley’s team of tax professionals provide comprehensive tax compliance and consulting services so you can preserve, enhance, and pass on your assets and wealth to the next generation. We welcome the opportunity to discuss the current options available for you. For more information, contact us today.