Much has been written about the California Pass-Through Entity Tax Credit since the state legislature passed Assembly Bill 150 in July 2021 by a broad bipartisan majority. Here's an overview of how these tax credits affect taxpayers, and what pass-through entities and owners should be aware of as the law enters its second tax season.
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.
By way of example, 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. The following will show some of the nuances of the California PTE; these are important for entity members and their tax preparers to be aware of.
A PTE recap
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 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. Publicly traded partnerships do not qualify. Qualified 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 that is owned by an individual, fiduciary, estate or trust subject to California personal income tax.
To qualify, 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 passed Senate Bill 113, which amended the PTE tax and tax credit in meaningful ways:
- 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.
The following scenario illustrates how an entity's election of the PTE credit can affect an individual or entity owner.
Let's say AA Distributors LLC is equally owned by two members. In 2022, AA will generate qualified California source net income of $450,000. Both members qualify and elect to make the PTE election. The LLC will be required to pay a PTE elective tax to the California Franchise Tax Board of $41,850 ($450,000 x 9.3%). Each member will report net income of $204,075 [($450,000 – $41,850) X 50%)] on their respective federal Schedule K-1 tax forms. Their California K-1 will report $225,000 of net income from AA ($204,075 federal income, plus $20,925 share of PTE tax paid to California). Additionally, their California Schedule K-1s will report a California tax credit of $20,925 to be applied against their individual California income tax liability. Each member would then benefit by reducing their federal pass-through income by $20,925.
What should filers and tax preparers be aware of?
The law has only been on the books for one tax season and, with the 2022 filing year upon us, it is important that California entities, owners and their preparers recognize the many issues that can affect their PTE tax credit. Just a few of these include the effect of the election as it relates to nonresidents. If a pass-through entity has nonresident shareholders, members or partners, then 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 any non-qualified shareholders to avoid jeopardizing the entity's S corporation status.
Further, the PTE's timely filing is critical, as the pass-through entity will be required to make minimum estimated tax payment(s) on or before June 15, 2022, and each succeeding year through 2026. Finally, and unique to California, each qualified taxpayer is entitled to a nonrefundable credit that can be carried forward for up to five years, or until used up.
Added to the technical issues cited above, there is also the need for clear lines of communication among entity members, the entity's financial management and the tax preparers for both owners and the entity itself. For instance, the preparer of an individual owner's tax return is likely not the same as the preparer for the entity making the election. Moreover, some owners within the entity may decide not to elect into the PTE, and this is information that must be made known to the entity's preparer. In short, whoever oversees financial reporting for the entity should make sure that all the owners are aware of their elections and the amount that has been paid on their behalf. This is a conversation that should be made before the election is made.
Looking ahead
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.
California is facing stiff competition from lower-tax states and is seeking ways to reduce tax burdens where possible. The PTE is clearly an example of this effort, and — if its bipartisan popularity with state politicians is any evidence — additional mitigating steps may be forthcoming.
