California legislature recently passed SB 113, modifying the state’s elective tax on passthrough entities (PTE). The signing of this much anticipated bill makes taxpayer-friendly adjustments to the existing PTE tax law beginning (retroactively) on January 1, 2021, through January 1, 2026. In doing so, California joins the list of other states that have implemented optional PTE taxes as a workaround to the $10,000 federal cap on deducting state and local taxes.
What’s new in a nutshell:
• Expands eligibility for the PTE tax to entities that have a partnership as a partner, member, or shareholder (beginning 2021)
• Changes the definition of “qualified taxpayer” to include LLCs
• Qualified taxpayers receive a credit for their share of the entity-level tax, reducing their California income tax
• Eliminates the PTE tax credit from being subject to the “tentative minimum tax”
• Includes guaranteed payments as qualified net income subject to the PTE tax
• Requires the elective tax credit to be applied after tax credits paid to other states
Qualified Entities and Qualified Taxpayers
A “qualified entity” is an entity that is taxed as a partnership or S corporation. Prior to the passage of SB 113, if an entity owner was a partnership, the PTE election was prohibited. SB 113 makes the PTE election available to entities with partnership owners retroactive to January 1, 2021.
What SB 113 does not change is the ability for a qualified entity to pay taxes on the behalf of a partnership owner, since a partnership owner is not considered a “qualified taxpayer.” However, SB 113 expands qualified taxpayers to encompass SMLLCs and provides for payment of tax by a qualified electing entity. Furthermore, an SMLLC owner – whether that be an individual, estate, or trust – is eligible to claim the tax credit on their own California tax return.
Key Point: Qualified entities and qualified taxpayers must do business in California and have a California filing requirement. An entity located outside of and not doing business in California is ineligible for the election, without regard to the California residency status of its owner(s).
Qualified Net Income and Guaranteed Payments Subject to PTE
SB 113 updated qualified net income inclusions to incorporate guaranteed payments, which the FTB had previously excluded. Therefore, the sum of any guaranteed payments and shares of income–distributive or pro rata–are subject to the 9.3% qualified net income tax.
It’s important to note, however, that this applies only to owners who have consented to the PTE election provision. An owner cannot be required to have the entity pay tax on its behalf, which will reduce the entity’s reportable amount of qualified net income. This has the greatest impact on S corporations and all K-1 reportable income, as it can create unequal distributions amongst owners.
Additionally, it is recommended that both partnerships and S corporations amend their current operating agreements, or draft a new agreement, to address and track the allocations specifically affected by the PTE elective tax deduction.
Entity Tax Allocation
Unless the IRS provides different guidance for S corporation payments, there would be equal allocation to owners according to their respective percentage of ownership. This is irrespective of an owner’s consent to the PTE election provision. The result is then consenting qualified owners (those who opted for the increased state tax deduction by “paying in”) not actually receiving the full benefit of what they paid in for.
Provided it is permissible according to the terms of the operating agreement, partnerships are allowed a provision to make specific allocation deductions. Even so, such entities remain responsible for ensuring such payments made for certain partners, but not others, are provided compensation.
Tax Credit Ordering
With SB 113, the PTE elective tax credit was re-categorized, placing it behind other higher-level credit categories, however, before the Other State Tax Credit. The benefit of which is a tax liability reduction as it applies to California, but will then reduce the Other State Tax Credit benefit.
No Longer Subject to the “Tentative Minimum Tax”
SB 113 also eliminated the PTE elective tax credit, being limited by the “Tentative Minimum Tax” based on the taxpayer’s total income. This greatly expands the potential benefit to taxpayers.
Net Operating Loss (NOL) and Tax Credits
SB 113 also removes the previous AB 85 (2020) California suspension for NOLs and tax credit limitations for the 2022 tax year for Californian businesses with a minimum taxable income of $1 million. The new bill also repeals the $5 million business credit limitation for higher income taxpayers. Additionally, the bill limits the use of business tax credits, such as research-and-development credits, for tax years 2020-2022 to $5 million annually.
We anticipate most 2021 passthrough entities (partnerships, LLCs taxed as partnerships, and S Corporations) will want to file an extension.
How to Elect
PTE elections are subject to annual renewal via the submission of FTB Form 3804 (not yet available) with an original return that was filed timely, including those who timely submitted an extension of time to file. Once made, the election is irrevocable, meaning filing a superseded or amended return will not revoke the applicable tax year’s election.
Furthermore, failure to make timely tax payment for the applicable tax year by the March 15 due date will nullify the PTE election. Remember, an extension of time only extends the time to file an actual return. It does not extend the amount of time to pay any tax due as of the original due date, which is March 15, 2022, for the 2021 tax year.
For tax years 2022-2025, two payments are required to maintain PTE election eligibility: June 15 of the taxable year and March 15 of the taxable year’s original filing deadline. For example, if an entity intends to make the annual PTE election for the 2022 tax year, the first payment will be due by June 15, 2022 and the second payment will be due by March 15, 2023.
Be sure to consult with your tax advisor when considering the PTE elective tax credit, as there are important considerations as they relate to the applicable benefits and changes required to be made by an electing entity.
Co-Author, Jeff Spiegel, CPA
Co-Author, Chris Ricker, CPA
Senior Tax Manager
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties