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.

While consideration should be made for owners who may be in a California tax bracket less than 9.3% for 2021, as these individuals may not be able utilize all of the tax credit in the current year, the five-year period to carry it forward could mitigate this concern. Additionally, some taxpayer’s California income level varies from year-to-year. For these individuals, proper tax planning can help maximize one’s benefits.

Some owners for individual considerations may want to withhold consent to have their share of the PTE's income taxed at the entity level, but it does not stop the entity from making the election on behalf other owners. This could, however, prove to be a logistical challenge for the PTE.

For individuals who are not California residents or only live in the state for part of the year, there are some non-California considerations related to the SALT workaround that are beyond the scope of this article. Do note these individuals can still 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. These individuals should however consult with a specialist before making any decisions.

For individual sole proprietors and single-member LLC (SMLLC) owners, there is an opportunity to restructure their operations to benefit from the SALT workaround. For example, if an SMLLC owner brought on a 1% partner, the now multi-member LLC could be taxed as a partnership. This new LLC structure could then elect the California SALT workaround.

Is The SALT Workaround Right For Your Company?
Utilizing California's SALT workaround law for eligible pass-through entities could significantly reduce the owners’ federal income tax bills. However, owners must consult with a qualified accountant to see if this solution is suitable for the entity. Additionally, owners will need to examine partnership or LLC operating agreements to determine if a SALT workaround election is allowed, and if so, who is authorized to make the decision. S corporations in particular will require attention in the case that one or more owners does not consent. The tax community is still awaiting further guidance from the IRS and the California Franchise Tax Board regarding final rules, so note that the specifics may look slightly different from what we know now.

Elaine Leung is a director in the tax practice at BPM, one of the 50 largest public accounting and advisory in the U.S, where she serves as a leader in the firm’s State and Local Taxes (SALT) team.

With over 20 years of experience in individual, corporate and partnership taxation, Bob McGrath is a director in the tax practice at BPM. He works primarily with high-net-worth individuals to craft personalized strategies.