On July 16, 2021, Gov. Gavin Newsom signed Assembly Bill 150, providing certain qualified pass-through entities an annual election to pay state income tax at the entity-level. The election may be beneficial for pass-through entities with certain individual partners, members or shareholders currently capped by the $10,000 federal state and local tax deduction limitation on individuals.
What is a qualified pass-through entity?
A pass-through entity is qualified to make the election if they are an entity taxed as a partnership or S corporation, with partners, members or shareholders consisting only of individuals, fiduciaries, trusts, estates, or corporations. Qualifying entities do not include entities disregarded for federal income tax purposes, or pass-through entities with partners that are partnerships. Additionally, publicly traded partnerships, or entities that are required to be included in a California combined reporting group cannot make the pass-through entity election.
The election is made on an annual basis and is effective only for tax years beginning on or after Jan. 1, 2021, and ending before Jan. 1, 2026. The election will sunset as of Dec. 1, 2026, and will also automatically repeal if the federal limitation on the state and local tax deduction is repealed. The election must be made on an original, timely filed return and is irrevocable for each tax year the election is made. A qualified pass-through entity may include only the pro rata share of distributive income from its partners, shareholders, or members that have provided consent. Additionally, a partner, shareholder, or member that has not provided consent will not prevent a qualified entity and electing owners from making the election.
Pass-through entity tax credit
Pass-through entities that make the election will pay a 9.3% tax on the total of each consenting owners’ pro rata share of distributive income subject to tax in California. This tax will apply for California residents on their entire distributive share, and for nonresidents, their California source amount. For tax years beginning on or after Jan. 1, 2021, and ending before Jan. 1, 2022, the tax is due on or before the original due date of the entity’s return, without regard to extensions. For tax years beginning on or after Jan. 1, 2022 and ending before Jan. 1, 2026, the tax is paid in two installments. The first installment is due on or before June 15th of the taxable year of the election and is the greater of $1,000, or 50% of the tax paid in the prior year. The second installment is due on or before the due date of the original return without regard to the extensions, and should cover any remaining amount due for that taxable year.
Consenting owners of pass-through entities making the election may claim a nonrefundable credit on their respective California tax returns equal to their pro-rata share of the entity-level tax the qualified pass-through entity paid. Any remaining unused credit can be carried forward for five years. Pass-through entity owners utilizing other credits, including taxes paid to other states, may face limitations on the use of the pass-through entity tax credit. Owners should consider the impact any additional credits may have on their overall tax profile to determine whether the election is beneficial.
It should be noted that the pass-through entity tax election does not satisfy a nonresident partner, shareholder or member’s filing requirement regardless of whether their liability is covered by the credit. Nonresidents are still required to file a return, or may elect to be included in a composite return, assuming they qualify.
California joins at least 17 other states that have adopted an election for pass-through entities to pay entity-level tax through the date of this article. Several more state workaround proposals are pending. While Assembly Bill 150 attempts to provide pass-through entity owners a mechanism to reduce the impact of the federal state and local tax deduction limitation, there are some key items that pass-through entity owners should consider in determining whether the election is beneficial. Some of these considerations include, but are not limited to:
- The 9.3% tax does not reflect California’s highest marginal rate for individuals, and the election may prevent individuals from taking credits or deductions normally available to that individual on their distributive income from the electing pass-through.
- Taxpayers may find it difficult to utilize all of the credit within the carryforward period when they have other credits or losses from other activities and investments.
- California may apply different sourcing rules between resident and nonresident individuals, and entities. Taxpayers should consider the effect these rules have in determining whether there is a benefit of an election.
- Structuring opportunities may be available to provide access to the election or increase the benefit. Taxpayers should consider whether it makes sense to establish special purpose pass-through entities for qualifying partners, shareholders or members.
Each partner, shareholder or member of an electing pass-through will need to model out the potential benefit of the additional state and local tax deduction to determine if election makes sense for their tax profile. Taxpayers with questions regarding the potential benefits of a California pass-through entity tax election should consult with their California state and local tax adviser for more details.