California recently joined a growing list of states that have created a SALT workaround for pass-through entities. The Tax Cuts and Jobs Act, passed in 2017, limits an individual’s annual federal deduction for SALT paid to $10,000 for tax years 2018 through 2025. Like other SALT workarounds, California's Assembly Bill 150, effective for tax years starting on or after Jan. 1, 2021, allows certain pass-through entities (PTEs) to pay and deduct California taxes at the entity level thereby providing a benefit for eligible owners.
How It Works
States that have passed SALT workarounds have utilized what is called a “PTE tax.” 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 rather than the individual level, taxes paid to states are allowed as a federal tax deduction by these entities in calculating their taxable income. Because of this, taxes paid to states by eligible pass-through entities are deducted at the federal level and not subject to the $10,000 cap.
Prior to 2021, fewer than 10 states had enacted a SALT workaround. Now, there are nearly 20, including high-tax states like New York and New Jersey. These so-called SALT workarounds either give owners tax credits against their personal income taxes or allow them to exclude their share of PTE income for state income tax computations. In Notice 2020-75, the IRS approved the PTE workaround and clarified that "specific income tax payments" or PTE taxes are allowed as a deduction and not subject to the $10,000 annual SALT cap.
What's In The New California Law?
Under California AB 150, certain PTEs can elect 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 an S corporation, and partnerships (excluding publicly traded partnerships)—can elect to pay this tax as long as:
1. The entity's partners, shareholders or members are corporations, individuals, fiduciaries, estates or trusts; and
2. The entity is not permitted or required to be part of a combined reporting group.
The bill allows consenting owners of the electing pass-through entity a non-refundable tax credit equal to 9.3% of their pro-rata or distributive share of qualified net income. The bill enables owners to carry forward any unused credit for up to five years after the tax year in which the credit is first claimed. The law also states that if the federal SALT limitation is modified or repealed before Dec. 1, 2026, California's PTE SALT cap workaround becomes inoperative.
For PTEs 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 better illustrate how the California PTE workaround can benefit owners, consider this example:
• Three individuals residing in California are each 33.3% 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 income is $500,000.
• The applicable California tax rate of 9.3% would see the LLC pay $46,500 ($500,000 X 9.3%) in state 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 $15,500—their share of the $46,500 California taxes paid by the LLC.
• The LLC passes through a $15,500 California 2021 tax credit to each owner. The non-refundable credit thus reduces the LLC owner's 2021 California tax liability dollar-for-dollar (but never below zero).
Things To Consider
Pass-through entities subject to California tax should carefully consider the impact the SALT workaround might have on their tax burden. First off, it is noteworthy that the federal tax benefit is greater for PTE owners who are in higher federal tax brackets.