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California’s recently enacted “SALT workaround” legislation enables owners of pass-through entities to bypass the $10,000 federal limit on state and local tax deductibility by allowing their businesses to pay an elective entity level tax of 9.3% of qualified California taxable income for tax years 2021 through 2025. This will enable owners to take a full deduction of this state tax on their federal tax returns.
As important, by making strategically timed payments of state tax estimates, pass-through entity owners can realize a significant corresponding federal tax benefit. The first deadline for such payment, which is the final payment for the 2021 tax year, is coming up on March 15, 2022. Payments made after this date will be subject to late payment and interest charges.
The federal Tax Cuts and Jobs Act (TCJA) of 2017 limited deductibility of state and local taxes (SALT) such as income and property taxes to $10,000 for individuals. This significantly impacts residents of California and other high property and income tax states. However, several states have provided relief for taxpayers who are owners of pass-through entities by enabling them to shift the SALT burden generated by the business to the entity level, where it is fully deductible on federal tax returns.
California’s Assembly Bill 150 was signed into law on July 16, 2021, providing the so-called “workaround.”
However, California’s state-level Tentative Minimum Tax (TMT) posed an obstacle for many pass-through owners by limiting the ability of owners to utilize the payment on their personal tax filings.
Subsequent legislation, which we were lobbying for, enacted on February 9, 2022, removed the onerous TMT limitation as it related to the provisions of AB 150, clearing the way for pass-through entities to fully deduct the AB-150 payment on federal tax returns while increasing the likelihood of owners being able to utilize the withholding on their California filing. It is important to remember that even with this recent change, there still are other limitations, such as a lack of refundability to consider.
A timing strategy play
The final estimated AB-150 tax deposit for those 2021 taxes is due on March 15, 2022, creating an opportunity for pass-through owners to benefit from the strategic timing of their deposits. The strategy can best be described by example:
A pass-through entity sole owner we’ll call Joe Contractor has been personally making quarterly estimated tax payments during 2021 and has additional wage and bonus state income tax withholdings as well. Assuming his 2021 tax liability in California is $100,000, and he’s already paid that amount through estimates and withholdings, he is therefore covered for having to make any more 2021 payments, but since the quarterly estimates were paid by him personally and not company paid AB-150 deposits, his federal SALT deduction will be limited to $10,000 under TCJA.
However, if his construction company makes an additional 2021 AB 150 deposit of $100,000 by March 15, 2022, and the related entity level elections, he would then have a total of $200,000 paid in state taxes for his benefit for 2021. This additional $100,000 would enable him to claim a 2022 federal tax deduction and receive a 2021 $100,000 California tax refund when he files his tax return for the overage.
Why pay the state $200,000 when he only owes $100,000? Because that $100,000 is a federal tax deduction against Joe’s 2022 qualified income, assuming he is in the 30% tax bracket, this saves him $30,000 in federal taxes.
This strategy is scalable and will be a more attractive benefit for higher-income taxpayers but will require careful balancing against other tax considerations to ensure the business owner maximizes the utilization of their 9.3% AB-150 deposit for the current year.
We’re here to help
If you believe this might benefit your organization, time is of the essence. Contact your JLK Rosenberger team member to discuss your strategy options, or click here to contact us. We look forward to speaking with you soon.