California enacts SALT cap workaround
INSIGHT ARTICLE |
Authored by RSM US LLP
On July 16, 2021, Gov. Gavin Newsom signed Assembly Bill 150, providing certain qualified pass-through entities an annual election to pay state income tax at the entity-level. The election may be beneficial for pass-through entities with certain individual partners, members or shareholders currently capped by the $10,000 federal state and local tax deduction limitation on individuals.
What is a qualified pass-through entity?
A pass-through entity is qualified to make the election if they are an entity taxed as a partnership or S corporation, with partners, members or shareholders consisting only of individuals, fiduciaries, trusts, estates, or corporations. Qualifying entities do not include entities disregarded for federal income tax purposes, or pass-through entities with partners that are partnerships. Additionally, publicly traded partnerships, or entities that are required to be included in a California combined reporting group cannot make the pass-through entity election.
The election is made on an annual basis and is effective only for tax years beginning on or after Jan. 1, 2021, and ending before Jan. 1, 2026. The election will sunset as of Dec. 1, 2026, and will also automatically repeal if the federal limitation on the state and local tax deduction is repealed. The election must be made on an original, timely filed return and is irrevocable for each tax year the election is made. A qualified pass-through entity may include only the pro rata share of distributive income from its partners, shareholders, or members that have provided consent. Additionally, a partner, shareholder, or member that has not provided consent will not prevent a qualified entity and electing owners from making the election.
Pass-through entity tax credit
Pass-through entities that make the election will pay a 9.3% tax on the total of each consenting owners’ pro rata share of distributive income subject to tax in California. This tax will apply for California residents on their entire distributive share, and for nonresidents, their California source amount. For tax years beginning on or after Jan. 1, 2021, and ending before Jan. 1, 2022, the tax is due on or before the original due date of the entity’s return, without regard to extensions. For tax years beginning on or after Jan. 1, 2022 and ending before Jan. 1, 2026, the tax is paid in two installments. The first installment is due on or before June 15th of the taxable year of the election and is the greater of $1,000, or 50% of the tax paid in the prior year. The second installment is due on or before the due date of the original return without regard to the extensions, and should cover any remaining amount due for that taxable year.
Consenting owners of pass-through entities making the election may claim a nonrefundable credit on their respective California tax returns equal to their pro-rata share of the entity-level tax the qualified pass-through entity paid. Any remaining unused credit can be carried forward for five years. Pass-through entity owners utilizing other credits, including taxes paid to other states, may face limitations on the use of the pass-through entity tax credit. Owners should consider the impact any additional credits may have on their overall tax profile to determine whether the election is beneficial.
It should be noted that the pass-through entity tax election does not satisfy a nonresident partner, shareholder or member’s filing requirement regardless of whether their liability is covered by the credit. Nonresidents are still required to file a return, or may elect to be included in a composite return, assuming they qualify.
California joins at least 17 other states that have adopted an election for pass-through entities to pay entity-level tax through the date of this article. Several more state workaround proposals are pending. While Assembly Bill 150 attempts to provide pass-through entity owners a mechanism to reduce the impact of the federal state and local tax deduction limitation, there are some key items that pass-through entity owners should consider in determining whether the election is beneficial. Some of these considerations include, but are not limited to:
- The 9.3% tax does not reflect California’s highest marginal rate for individuals, and the election may prevent individuals from taking credits or deductions normally available to that individual on their distributive income from the electing pass-through.
- Taxpayers may find it difficult to utilize all of the credit within the carryforward period when they have other credits or losses from other activities and investments.
- California may apply different sourcing rules between resident and nonresident individuals, and entities. Taxpayers should consider the effect these rules have in determining whether there is a benefit of an election.
- Structuring opportunities may be available to provide access to the election or increase the benefit. Taxpayers should consider whether it makes sense to establish special purpose pass-through entities for qualifying partners, shareholders or members.
Each partner, shareholder or member of an electing pass-through will need to model out the potential benefit of the additional state and local tax deduction to determine if election makes sense for their tax profile. Taxpayers with questions regarding the potential benefits of a California pass-through entity tax election should consult with their California state and local tax adviser for more details.
Call us at +1 213.873.1700, email us at email@example.com or fill out the form below and we'll contact you to discuss your specific situation.
This article was written by Craig Tatlonghari, Chris Gauss and originally appeared on 2021-07-30.
2021 RSM US LLP. All rights reserved.
The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.
RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each is separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/about us for more information regarding RSM US LLP and RSM International. The RSM logo is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.
Vasquez & Company LLP is a proud member of the RSM US Alliance, a premier affiliation of independent accounting and consulting firms in the United States. RSM US Alliance provides our firm with access to resources of RSM US LLP, the leading provider of audit, tax and consulting services focused on the middle market. RSM US LLP is a licensed CPA firm and the U.S. member of RSM International, a global network of independent audit, tax and consulting firms with more than 43,000 people in over 120 countries.
Our membership in RSM US Alliance has elevated our capabilities in the marketplace, helping to differentiate our firm from the competition while allowing us to maintain our independence and entrepreneurial culture. We have access to a valuable peer network of like-sized firms as well as a broad range of tools, expertise and technical resources.
For more information on how Vasquez & Company LLP can assist you, please call +1 213.873.1700.
Subscribe to receive important updates from our Insights and Resources.