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California business owners have been given a workaround to the $10,000 State and Local Tax (SALT) itemized deduction limit imposed by the 2017 tax reform that adopted elective pass-through entity (PTE) tax legislation. On July 16th, the Governor signed AB 150, a budget trailer bill containing language outlining California’s PTE tax guidelines that other states have also been passing since receiving some prior approval from the federal government. For the right clients, especially those with substantial CA taxable income, the PTE may be a boost to cash flow by reducing their federal income tax burden.
S Corporations and Partnership (or LLCs taxed as either), collectively PTEs, will, in essence, be able to elect to pay a 9.3% tax to CA. In return, the business will deduct this state income tax on their federal tax return, reducing the amount of federal income tax paid by the PTE owners. At the same time, the electing owners will claim a credit for the 9.3% tax paid to CA. In essence, the business pays the tax, federal income is reduced, and the owner takes a credit for the CA tax paid. However, the big picture is hardly ever the whole picture.
Entities that are taxed as a partnership or an S Corporation may qualify. Each owner of the PTE may separately elect to be part of the PTE tax or not, which may create some of its own issues. Further, if an owner of the PTE is itself a disregarded entity (mainly a single member LLC not taxed as an S Corp) or a partnership, then these structures are not able to participate in the PTE tax. This may create some challenges and opportunities for choice of entity discussions.
What about Wage Earners?
Unfortuantely, the PTE tax only applies to PTE and their owners. As such, if your sole source of income is from wages, you will not benefit from the PTE tax regime and still feel the full force of the SALT limitation.
How much is the PTE Tax?
The PTE tax appears to be a flat 9.3% of CA qualified net income. There may be some adjustments, but for a CA resident with a PTE wholly operating in CA, it would be approximately 9.3% of your CA business pass-through income.
Wait, but I don’t pay 9.3% CA tax?
This will be part of the rub. The state does not appear to be allowing a lower threshold. In order to have 9.3% effective CA tax, your income will be relatively high. So, it is possible that the PTE tax may be higher than your CA tax on your income. In this case, we will need to analyze the federal tax savings and compare to the CA tax “cost.”
Is the PTE tax refundable or able to be carried over?
Unfortunately, the PTE tax does not appear to be refundable. So, if your main source of income is your PTE, unless you are higher income, the 9.3% PTE may be higher than your actual CA tax. Since it is not refundable, you will not get a refund of that PTE credit (you may still get refunds of other payments made), but it does appear to be able to be applied to the next year. We can possibly see scenarios where a taxpayer elects to skip the PTE tax regime in order to utilize their carryover.
When does the PTE tax start?
The PTE tax appears to start with the current 2021 tax year. This may impact future quarterly taxes and other planning.
How much will I save?
As any tax professional will say…it depends! It truly will be a case-by-case determination. For those in the highest tax brackets (think $1.1M+), the savings may be in the range of around 3.6% +/- of your business income (just flow through income). So, if your business income is $1.1M, the savings may be around $40K. For those whose businesses are not making as much, the savings will be much lower. There will be some that the PTE just does not make sense for various reasons and the savings will not be there at all.
What do I do next?
Since the election for 2021 appears to be made with the original, timely filed 2021 tax return, there does not appear to be a near-term time-sensitive date. However, we will want to implement this planning opportunity during 2021. It may even make sense to pay the PTE tax prior to year-end, even though for 2021, the PTE tax does not appear to be due until March 15, 2022. We expect there to be many questions about this new law, and the answers will be slow to come, so patience, flexibility, and communication will continue to be needed. So, essentially your tax advisor will want to make a determination on whether this is right for you or not and plan for this opportunity.
Is this right for everyone?
No, there are various limitations on CA’s PTE tax benefits. The PTE tax will not be right for all of our business clients. Some taxpayers may not be operating in the proper tax structure, some may have income limitations, some may have ownership issues, while some may have other issues. However, I would say that this is something all of our business clients will be wanting to take a look at to see how we can minimize the tax burden.
I expect there to be many questions about this new law (I know I already have my list, and it keeps growing) while the answers will be slow to come, so patience, flexibility, and communication will continue to be needed when tax planning. Some taxpayers, such as lower income businesses or wage earners, may not see any benefit, but certain businesses may see large benefits which we will need to be sure that steps are taken to secure those benefits. As such, it seems to be prudent for taxpayers to be aware of this opportunity and allow us to help in determining if electing into the PTE tax is appropriate.
We’re Here to Help
If you have questions about how this applies to you, JLK Rosenberger can help. For additional information, reach out to your JLK Rosenberger team member or call us at 949-860-9902. You can also click here to contact us. We look forward to speaking with you soon.