The Pass-Through Entity Tax (AB 150) and SB 113 Amendments
In July 2021, California passed Assembly Bill 150, which contained the Small Business Relief Act, adding Sections 17052.10 and 19900, et seq., to the Revenue and Taxation Code. The Small Business Relief Act allows a partnership or S corporation to elect to pay California income tax at the entity level and pass on the federal deduction to its owners, with owners also receiving a California tax credit, and is often referred to as the “pass-through entity tax” (PTET). Senate Bill 113, passed earlier this year, made clarifying amendments to the PTET. This blog post reviews the PTET and summarizes the SB 113 amendments.
Overview of the PTET
Ever since the 2017 Tax Cuts and Jobs Act imposed a $10,000 limitation on the deductibility of state and local taxes (SALT cap), taxpayers and state legislatures have been considering alternatives to get around the SALT cap. In 2020, the IRS issued Notice 2020-75 which blessed state legislative frameworks to allow state income taxation at the entity level, with pass-through entities taking the federal deduction for state taxes without the SALT cap limitation, and passing that deduction on to their owners in the form of a reduction in allocated net income.
In 2021, California enacted AB 150, of which the PTET was a part. The PTET allows Qualified Entities to elect to pay a 9.3% California income tax on California-sourced income for tax years from 2021 through 2025. The federal deduction for state income tax paid is not subject to the SALT cap, and reduces the taxable income allocated to the owners of the Qualified Entity. Additionally, Qualified Taxpayers receive a credit against their California income tax liability based on their pro rata or distributive share of the Qualified Entity’s income.
A “Qualified Entity” is an entity taxed as a partnership or S corporation. As originally passed, the PTET provided that the owners of a Qualified Entity could be any taxpayer other than another partnership, which would disqualify the entity. As discussed below, this was amended by SB 113 so that the owners of a Qualified Entity can now be corporations, individuals, partnerships, fiduciaries, estates or trusts. Excluded from Qualified Entities are publicly traded partnerships and partnerships that are part of a combined reporting group.
A “Qualified Taxpayer” is an individual, fiduciary, trust, or estate. Corporations and partnerships are not included. The way in which a Qualified Taxpayer “consents” is not specified. Furthermore, there is no requirement that all, or even a majority, of the owners of a Qualified Entity consent. Nonconsenting owners are simply left out of the calculus, as their pro rata or distributive share of the entity’s income will not be subject to the entity-level tax, and the nonconsenting owners will not receive the California tax credit.
A Qualified Entity elects to pay the PTET on an annual basis on a timely filed California tax return for the tax year. For tax year 2021, the elective tax was due on or before March 15 (excluding extensions) for calendar year entities. The tax is paid using FTB Forms 3804 and 3893 for 2021.
For tax years 2022 through 2025, the elective PTET is due in two installments: (i) the first installment is due on June 15th, and is the greater of $1,000 or 50% of the elective tax paid the previous year; (ii) the second installment is due on or before March 15th of the subsequent year.
The SB 113 Amendments
SB 113, signed into law in February of 2022, made the following changes to the Small Business Relief Act and the PTET:
- As mentioned above, having a partnership as an owner no longer excludes an entity from being a Qualified Entity.
- A single-member LLC, disregarded for tax purposes, which is an owner of a Qualified Entity, is now eligible to be a consenting Qualified Taxpayer if the owner of the LLC is a Qualified Taxpayer (e., an individual, fiduciary, trust, or estate).
- “Guaranteed payments,” as defined in IRC Section 707(c), are now added to a consenting Qualified Taxpayer’s pro rata or distributive share in calculating the Qualified Taxpayer’s portion of the PTET to be paid, and California tax credit to be received.
- The tentative alternative minimum tax limitation on the PTET credit is repealed. Previously, taxpayers who owed a certain minimum tax under California’s alternative minimum tax regime could not use the PTET credit to reduce their tax liability below their tentative minimum tax amount. Now, taxpayers who owe the tentative minimum tax may reduce this tax liability by the amount of their PTET credit.
- Beginning in 2022, in determining how much a taxpayer’s net tax is reduced by various credits, the PTET credit will be applied against the net tax after credits for taxes paid to other states have been applied. Any portion of the California tax credit which is not used may be carried forward for up to five years (but these credits may expire when the PTET expires after 2025).
- Qualified Entity Election. With regard to the election by a Qualified Entity to pay the PTET, AB 150 does not specify who has the authority on behalf of the Qualified Entity to make the election. Presumably, the person with authority to make other tax elections under the entity’s organizational documents will have the authority to make the PTET election. However, given that the election means liability for the elective tax, owners may wish to amend the governing document of the Qualified Entity to set forth the required approval for the election.
- Qualified Taxpayer Consent. With regard to the consent by Qualified Taxpayers, AB 150 does not specify how such consent is to be given. Unless the Franchise Tax Board gives guidance, the safest course would be a written consent executed by both the Qualified Taxpayer and the Qualified Entity.
- Allocation of the Federal Deduction. In the case where some of the owners of an electing Qualified Entity are not consenting Qualified Taxpayers, an assumption among some commentators appears to be that the federal deduction resulting from the payment of the California income tax will be specially allocated to the consenting Qualified Taxpayers. The California statutes do not address the allocation of the deduction for federal tax purposes. Section 3.02(3) of IRS Notice 2020-75 provides that the deduction “does not constitute an item of deduction that a partner or an S corporation shareholder takes into account separately,” but rather is reflected in each partner’s or shareholder’s distributive or pro rata share of the entity’s income. Accordingly, the deduction would have the effect of reducing the net income allocated to all owners based on their distributive share.
- Economic Parity for Non-Consenting Owners. In the case where some of the owners of an electing Qualified Entity are not consenting Qualified Taxpayers, the Qualified Entity pays the PTET based on the sum of the pro rata or distributive share of income of the consenting Qualified Taxpayers, and they reap the benefit of the California tax credit regardless of how the federal deduction is allocated. The non-consenting owners may require that the economic burden resulting from the Qualified Entity’s payment of the PTET is borne solely by the consenting Qualified Taxpayers. This may be accomplished by amending the Qualified Entity’s governing document to provide, for example, a special distribution to the non-consenting owners.
- S Corporation Considerations. A service provider or other sole proprietor may wish to take advantage of the PTET by forming an S corporation and thereby becoming a Qualified Taxpayer of an electing Qualified Entity. This advantage, however, would be limited by the requirement of an S corporation to pay “reasonable compensation” to its employee-shareholders, which could significantly reduce the amount of income subject to the PTET. Also, some commentators have mentioned that having both consenting Qualified Taxpayers and non-consenting taxpayers among the shareholders of an S corporation could raise the issue of multiple classes of shareholders, which would invalidate the corporation’s S status.
- Using the PTET to Reduce Taxable Gain. In advance of a taxable sale transaction, an individual might consider forming a Qualified Entity, and contributing the property to that entity. The Qualified Entity electing to pay the PTET would not be subject to the SALT cap on the federal deduction for the California tax paid on the gain from the sale, which would reduce the net gain allocated to the individual Qualified Taxpayer.
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