PLEASE SEE FEBRUARY 8, 2022 UPDATE REGARDING RETROACTIVE CHANGES INCLUDED IN CALIFORNIA AB 87 (SB 113).
On Friday July 16, 2021 California Governor Gavin Newsom signed Assembly Bill 150. This bill contains a mixture of tax relief measures, which includes the following:
SALT Cap Deduction Election for Passthrough Entities Overview
Prior to the 2018 tax year an individual taxpayer could deduct certain state and local taxes (including state income taxes) without limitation for federal purposes. In late 2017 congress passed the Tax Cuts and Jobs Act (TCJA) which imposed a $10,000 limitation for state and local taxes, severely limiting what was most taxpayer’s largest itemized deduction. This limitation hit taxpayers living in high tax states like California especially hard as this indirect tax rate increase sent their effective tax rates between federal, state and local taxes soaring to over 50%. California has now joined the growing list of states since the passage of TCJA which have implemented a workaround using passthrough entities in order to minimize the impact of the limitation for their residents and taxpayers.
For taxable years 2021 through 2025, California Assembly Bill 150 establishes the Small Business Relief Act, which allows qualified passthrough entities that are required to file a California tax return, to elect to pay and deduct a passthrough entity tax of 9.3% on qualified net income, which is the sum of the distributive share of an entity’s income. This elective entity level tax is deductible by the entity for federal purposes (as confirmed in IRS Notice 2020-75) thereby effectively bypassing the federal SALT limitation that applies to individuals on the tax attributable to the passthrough entity’s income.
Why This Matters
If you are an owner in a qualified passthrough entity (S-corporation or Partnership) and incur a personal state tax liability in excess of $10,000 each year, then this bill may allow you to indirectly increase your annual state tax deduction on your personal income tax return, in excess of the $10,000 individual limitation, and as a result, reduce your overall Federal income beginning with the 2021 tax year.
Who Can Utilize The Passthrough Entity Tax
Qualified entities can make this irrevocable election on an annual basis on an originally timely filed tax return. Qualified entities include:
Qualified entities do not include:
- Publicly traded partnerships
- An entity that is permitted or required to be in a combined reporting group
- An entity that has a partnership owner
Eligible passthrough entity owners can elect to have their share of income subject to the passthrough entity tax. Each eligible owner can choose if they want the entity to pay the tax on their share of the entity’s income. An owner that does not consent does not prevent the qualified entity from making an election to pay the elective tax.
Eligible passthrough entity owners include:
Eligible passthrough entity owners do not include:
This SALT deduction limitation workaround will be in effect for tax years on or after January 1, 2021 and before January 1, 2026. However, if the Federal $10,000 SALT deduction limitation is repealed, the elective passthrough entity tax would become inoperative on the following January 1st.[GPW Insight: Individuals operating a business as a sole proprietorship may want to consider converting to a partnership or S corporation in order to take advantage of this provision.]
Elective Passthrough Tax Due Dates
For tax years beginning on or after January 1, 2021 and before January 1, 2022, the elective tax shall be due and payable on or before the due date of the original tax return for the qualified entity without regard to any extensions (March 15,2022 for a calendar entity).
For each taxable year beginning on or after January 1, 2022 and before January 1, 2026 the elective tax shall be due and payable in two increments:
- The first installment is due on or before June 15th of the taxable year of the annual election, which is to be the greater of either 50% of the elective tax paid the prior taxable year or $1,000.
- The second installment is due on or before the due date of the original return for the qualified entity without regard to any extensions (March 15th for a calendar entity).
Passthrough Entity Owners Eligible To Claim A Nonrefundable Credit
The consenting passthrough entity owners can also claim a nonrefundable credit for the amount of tax paid on the owner’s distributive share of the entity’s net income. The credit is allowed in full for residents, non-residents and part-year residents and is not required to be pro-rated. The unused credits can be carried forward for up to five years.