As part of the Tax Cuts and Jobs Act of 2017, the deduction for state and local taxes (SALT) was limited to $10,000 for both single and married taxpayers. This limitation had unfavorable consequences for many taxpayers, including many middle-class taxpayers living in high tax states such as California and New York. As part of the budget deal reached for California, the governor signed AB 150 which includes provisions for the elective passthrough entity tax. For tax years 2021 through 2025, qualified S-corporations, partnerships and LLCs that are required to file a California tax return can elect to pay a passthrough entity tax of 9.3% on qualified net income. Owners will claim a nonrefundable credit for the amount of tax paid on their share of the passthrough income. If not utilized, the credit can be carried forward for up to five years.
What entities are eligible to make the election?
In order to be eligible to make the election, an entity must:
What is qualified net income?
Qualified net income is the total distributive share of income of the passthrough entity’s individual, trust, and/or estate owners that consent to have their share of income subject to the tax. Each eligible owner can decide whether or not they want the entity to pay the 9.3% tax on their share of the income.
Why make the election?
This election will allow the passthrough entity to pay tax at the entity level which reduces the amount of federal taxable income passed through to owners. Tax at the entity level is not subject to the $10,000 federal SALT limitation; therefore, owners will be able to effectively reduce their taxable income without potentially losing all or a portion of the SALT deduction to the limitation. Additionally, because the deduction will decrease passthrough income from the entity, the owners’ adjusted gross income will decrease which has the potential for other favorable outcomes, such as a smaller portion of social security subject to tax and increased allowable itemized deductions for medical expenses.
When and how will an entity make the election?
The election is made annually as part of the tax return filing of the entity. It can only be made on an original, timely filed income tax return. For tax year 2021, the passthrough entity tax is due on the due date of the 2021 tax return (without regard to extensions). For calendar-year taxpayers, this due date is March 15, 2022.
For tax years 2022-2025, entities will be required to make two payments. The first payment is due June 15, or the 15th day of the sixth month of the taxable year in the case of fiscal-year taxpayers. The required payment is the greater of:
The remaining balance due must be paid by the original filing deadline of the entity (March 15 for calendar-year taxpayers).
If the entity fails to remit the first payment, they are disqualified from making the election for that tax year.
What action should business owners take now?
Business owners who think that they may benefit from this new state provision are encouraged to contact us to discuss the specifics of their situation and begin preparing for a potential cash outflow during the first quarter of 2022 if the election is made. In the case of multiple owners, thought should be given to whether or not it makes sense for all eligible owners to consent to the tax or if a 9.3% tax rate may be too high for some owners’ personal income tax situations. Unlike other workarounds that have been proposed over the past couple of years, such as “donations” paid to states rather than “taxes” paid to states, this workaround has been approved by the IRS and provides a great planning opportunity for business owners who are affected by the SALT limitation.