Workaround creates tax savings opportunities for owners of LLC’s, partnerships and S corporations
Governor Newsom last Friday signed California Assembly Bill 150, making California the latest state to enact a state and local tax (SALT) workaround law for pass-through businesses. The workaround, effective for tax years beginning on or after Jan. 1, 2021, allows certain pass-through entities to pay and deduct California taxes at the entity level thereby providing a benefit for eligible owners.
The background for all this is the federal Tax Cuts and Jobs Act, passed in late 2017, which limits an individual’s annual federal deduction for SALT paid to $10,000 for tax years 2018 through 2025. In response to the cap, a number of states have passed tax laws that impose mandatory or elective pass-through entity taxes as a workaround to the annual individual limitation.
How It Works
A pass-through entity (PTE) tax is similar to a corporate tax, but instead applies to LLCs, partnerships and S corporations. When pass-through entities are taxed at the entity level rather than the individual level, taxes paid are allowed as a federal tax deduction by these entities in calculating their taxable income. Therefore, taxes paid by eligible pass-through entities are deducted and are not subject to the annual $10,000 cap.
States that have enacted a SALT workaround also either allow owners a tax credit against their own personal income taxes or allow owners to exclude their share of PTE income for state personal income tax computation.
The IRS in Notice 2020-75, issued in November 2020, approved the PTE workaround and clarified that “specified income tax payments” or PTE taxes are allowed as a deduction, and not subject to the $10,000 annual SALT cap. Forthcoming proposed regulations by the IRS will hopefully provide more clarity on certain federal tax issues that the PTE workarounds present for partnerships and S corporations.
What’s In the New California Law
California’s Assembly Bill 150 provides an election that allows for certain pass-through entities to pay a 9.3% tax on the California income of consenting PTE owners, in turn allowing the PTE’s consenting owner to claim a credit on their California tax return for the PTE’s taxes paid on their behalf.
Specified pass-through entities — S corporations, LLCs taxed as a partnership or as an S corporation, and partnerships (other than publicly traded partnerships) — can elect to pay this tax as long as:
The entity’s partners, shareholders, or members are corporations, individuals, fiduciaries, estates, or trusts; and
The entity is not permitted or required to be part of a combined reporting group.
Under the bill, the entity’s annual election to pay the tax is both irrevocable and can only be made on an original, timely filed return for the taxable year in a form and manner as prescribed by the Franchise Tax Board (FTB). The bill allows consenting owners of the electing pass-through entity a nonrefundable tax credit equal to 9.3% of their pro-rata or distributive share of qualified net income subject to the election. The measure allows owners to carry forward any unused credit up to five years after the tax year in which the credit is first claimed. The law also contains a provision that if the federal SALT limitation is modified or repealed prior to Dec. 1, 2026, California’s PTE SALT cap workaround becomes inoperative. The law authorizes the FTB to adopt regulations necessary or appropriate to implement these new provisions.
For PTE’s electing to pay the tax at the entity level for 2021, the PTE tax is due on or before the due date of the entity’s 2021 tax return (without regard to extensions).
To illustrate how the California PTE workaround can benefit owners, assume the following:
Three California resident individuals are each 33.3% owners of an LLC taxed as a partnership.
Each of the LLC members provides consent to have their share of the LLC’s income taxed at the LLC level.
In 2021, the LLC’s taxable income is $300,000.
If the LLC makes an irrevocable election on its timely filed 2021 return to pay tax at the LLC level at the applicable California tax rate of 9.3%, the LLC would pay $27,900 ($300,000 x 9.3%) in California taxes.
This results in the following:
- The California taxes paid by the LLC are deductible for federal tax purposes but not for California tax purposes.
- In this simplified example, each owner’s 2021 Schedule K-1 federal taxable income from the LLC would be reduced by $9,300 — their share of the $27,900 California taxes paid by the LLC (assuming the LLC paid the California taxes in 2021).
- The LLC passes through a $9,300 California 2021 tax credit to each owner. The nonrefundable credit reduces the LLC owner’s 2021 California tax liability dollar-for-dollar but not below zero.
- Any excess credit on the owner’s 2021 tax return is available to be carried forward for five years.
Comments and Observations
Every eligible pass-through entity with a taxable presence in California should carefully consider California’s elective SALT workaround. The analysis should take into account the net impact on the owners of an election to pay California tax at the entity level versus not electing. Note that the election is made annually so each year stands on its own.
While special rules apply to California nonresidents and part-year residents, these individuals can consent to have their share of the PTE’s California tax paid at the entity level and claim the credit against their California tax liability. A discussion of the provisions applicable to California nonresidents and part-year residents is beyond the scope of this discussion. Consult a BPM SALT professional for a more detailed analysis of a taxpayer’s specific circumstances.
Not every eligible PTE owner will benefit from a PTE’s election to pay California tax at the pass-through level and then pass a California tax credit through to the owner. If the PTE’s owner’s California effective tax rate is less than 9.3%, the owner may not be able to utilize all of the credit in the current year. The five-year excess credit carryforward may, however, mitigate this concern. The eligible owner’s option to provide or withhold consent to have their share of the PTE’s income taxed at the PTE level provides the owner with flexibility, but it may provide logistical challenges for the PTE. We expect that the FTB will issue guidance on how and when the owner consent is to be provided.
This new law may present an opportunity for California individual sole proprietors and single-member LLC (SMLLC) owners to restructure their operations to benefit from the SALT workaround. For example, if an SMLLC owner brought on a 1% partner such that the now multi-member LLC was taxed as a partnership, the LLC could then elect the California SALT workaround. That said, restructuring an entity’s status is not a step that should be taken without a thorough examination of all the tax and non-tax consequences. This is particularly true in this situation in light of the law’s expiration after 2025 and the potential for federal tax changes to the SALT limitation.
Partnership and LLC operating agreements should be examined to determine if a California SALT workaround election is allowed, and if so, who is authorized to make that decision. Some operating agreements may contain distribution policies that may need to be revised to take into account an election to utilize California’s SALT workaround.
BPM’s cross-functional teams of Private Client Services, Pass-Through Entity and SALT specialists are available to assist you in analyzing how this new law may affect your operations. Please reach out to your BPM tax professional if you have questions or would like additional information.