On July 16, 2021, Governor Gavin Newsom signed Assembly Bill 150 into law. This bill enables certain California taxpayers to write off more than the $10,000 limit placed on state and local tax (SALT) deductions — but it’s not automatic, you need to know what to do to get this relief.
BRIEF HISTORY OF SALT LIMITATIONS
Prior to the 2018 tax year, an individual taxpayer could deduct certain state and local taxes (SALT) (including state income taxes) without limitation for federal purposes. This was especially important for those living in high income-tax states like California.
In 2017, however, Congress passed the Tax Cuts and Jobs Act (TCJA) which imposed a $10,000 limitation for state and local taxes paid by individuals, severely limiting what was most taxpayer’s largest itemized deduction. This limitation hit California taxpayers 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.
This will sound weird at first blush. To get the benefit, you pay a tax! Keep reading!
AB 150 establishes the Small Business Relief Act, which allows qualified small passthrough entities (partnerships and S corps) to elect to pay (and then deduct) a passthrough entity tax (PTE) of 9.3% on qualified net income. The PTE tax is deductible by the entity on federal taxes (pursuant to IRS Notice 2020-75) and the PTE owner can claim a dollar-for-dollar credit on their California tax return for the PTE’s tax paid on their behalf.
A PTE tax is similar to a corporate tax but instead applies to partnerships and S corporations. When a PTE is taxed at the entity level, taxes paid to the state are allowed as a federal tax deduction and are not subject to the $10,000 cap.
Interestingly, the IRS has seemed to uphold these elections, as articulated in IRS Notice 2020-75.
Consider this example:
- Four individuals residing in California are each 25% owners of an LLC taxed as a partnership.
- Each LLC member consents to have their share of the LLC’s income taxed at the LLC level.
- In 2021, the LLC’s taxable California income is $600,000.
- The applicable California tax rate of 9.3% would have the LLC pay $55,800 in state taxes.
This results in the following:
- The California taxes paid by the LLC are deductible for federal tax purposes
- Each owner’s 2021 Schedule K-1 federal taxable income from the LLC would be reduced by $13,950—their one-fourth share of the PTE tax paid by the LLC.
- The LLC passes through a $13,950 California 2021 tax credit to each member.
- The non-refundable credit thus reduces the LLC owner’s 2021 California tax liability dollar-for-dollar (but never below zero).
If you are an owner of a multi-member passthrough entity (S-corp or Partnership), and if you incur more than $10,000 of SALT annually, this bill may allow you to deduct more than the limit, and thus reduce your 2021 taxable income. Qualified entities include partnerships and S-corporations (where the partners are individuals, trusts, estates, and corporations) but exclude publicly traded partnerships, an entity (required to be) in a combined reporting group, or an entity that has a partnership owner.
Each eligible owner can elect to have their share of income subject to the PTE tax or not. An owner that does not consent does not prevent others from making the election.
The SALT deduction workaround will be in effect for tax years 2021 through 2025. But if the federal $10,000 SALT deduction limitation is repealed, this election would be inoperative the following tax year.
The credit on the state taxes can be carried forward five years.
There seem to be no restrictions placed on the trades or businesses that can qualify. Thus, an entity owning passive investments appears to qualify. It is possible that guidance limiting which entities are eligible will be forthcoming.
Talk to your tax preparer to make sure they analyze your situation to see if election makes sense.
Certain S corporations should be weary not to elect in such a way to invalidate S corporation status (as to create two class of shareholders).
Sole proprietorships should consider forming an LLC or S corporation, with a second member minority owner. If the LLC interest is community property, the owner may be eligible to elect to treat the single-member LLC as a multi-member partnership among spouses.
Those residents too who are lower than the 9.3% bracket, or who expect their California net taxable income to be lower than that realized at the entity level may also choose to opt out.
Bridge Law looks forward to guiding our clients and their advisors.