UPDATE: The governor signed A.B. 50 on July 16, 2021.
California is one step closer to joining the growing number of states adopting pass-through entity (PTE) tax legislation in response to the 2017 federal tax reform legislation. For federal income tax purposes, the 2017 tax reform limited individuals’ itemized deduction to $10,000 for their separately stated state and local income, sales, and property taxes (SALT).
On July 1, Assembly Bill 150 (A.B. 150), one of the two budget trailer bills that contained California’s iteration of the elective PTE tax language, was passed by the Senate 40-0 and by the Assembly 78-0 and has been presented to Governor Gavin Newsom (D) for final action.
Action item: While A.B. 150 seeks to make taxpayers whole by putting them in the same position in which they had been prior to the passage of the federal limitation, certain facets of the legislation will require qualifying partners/members/shareholders (collectively referred to as “partners”) to evaluate whether such an election would be beneficial or even whether the PTE is eligible to make an election on their behalf.
On November 9, 2020, the IRS released Notice 2020-75 (Notice), which recognized that certain states had enacted or were contemplating the enactment of PTE taxes in response to the $10,000 SALT deduction limitation. The Notice indicated the IRS’s acceptance of the practice where a PTE deducts the amount of PTE SALT taxes paid at the entity level from the PTE’s income for federal tax purposes as a fully deductible business expense not subject to the $10,000 itemized SALT deduction limitation. The deduction in turn, would reduce the partners’ distributive share of federal taxable income from the PTE without regard to the SALT deduction limitation. California subsequently proposed legislation to enact a PTE tax as a ‘workaround’ to the SALT deduction limitation, similar to those enacted by other states.
For tax years beginning on or after January 1, 2021 and before January 1, 2026, “qualified entities” can elect to pay an optional tax, and qualifying electing partners will receive a nonrefundable credit against their resident or nonresident California tax liability. This PTE tax will be in effect until the statutory sunset date of December 1, 2026 or the repeal of the SALT deduction cap, whichever comes first.
Qualified entities that: (1) are taxed as a partnership or an S corporation, and (2) have partners, shareholders, or members all of whom are corporations, individuals, fiduciaries, estates, or trusts, are eligible to elect into and pay the PTE tax on behalf of their qualified partners. The definition of qualified entity does not include publicly traded partnerships or an entity that is permitted or required to be in a combined reporting group.
A unique provision of the California PTE tax regime is that each qualifying taxpayer (i.e., an individual, fiduciary, estate, or trust) that is a partner of the entity may separately elect to be subject to the PTE tax. It should be noted that a corporation may be a partner in the qualifying entity however, may not separately elect to be subject to the PTE tax. A qualifying taxpayer that does not elect into the PTE tax does not disqualify the qualifying entity from making the election to pay the PTE tax.
Qualified entities must meet both prongs of the statutory definition to be eligible to elect into and pay the PTE tax. Entities that have a partnership or a disregarded business entity as a partner cannot take advantage of the PTE tax; this limitation will significantly impact the population of entities that will be eligible to elect into the PTE tax regime.
Observation: Due to these partner-type limitations and the potential of lost benefits by otherwise qualifying PTE partners, certain partners or PTEs may consider forming separate PTEs held by only qualifying partners to enable an election to be made. In contemplating such special purpose entities, taxpayers should consider the potential for business purpose challenges (e.g., whether intercompany agreements will be needed).
The PTE tax is calculated on the qualified net income of the qualified entity making the election to pay the PTE tax computed at the rate of 9.3%. “Qualified net income” is defined as the “sum of the pro rata share of distributive share of income subject to tax under Part 10 (commencing with Section 17001) for the taxable year of each qualified taxpayer, as defined in Section 17052.10.”
Observation: For California resident taxpayers, the tax base presumably would include all distributive income from the partnership; for non-resident taxpayers, the tax base would only include California source income. While Senate Bill 104 (S.B. 104), an earlier iteration of the PTE tax, would have made this point clear in statutory language, the language in A.B. 150 is somewhat more ambiguous and open-ended. Taking into account the backdrop of S.B. 104 and the PTE tax regimes enacted in other states, such a presumption of how a resident’s PTE income would be treated compared to the PTE income of a nonresident may be viewed as a reasonable interpretation of A.B. 150’s intent.
Observation: The highest marginal tax rate typically has been used among states that have enacted similar PTE taxes to help taxpayers maximize the benefit of the PTE tax and, in certain instances, to alleviate the nonresident filing requirements in those states. For California purposes, nonresidents still will be required to either (1) file a nonresident income tax return, or (2) elect to be included in a composite tax return, even if their California tax liability is covered by the nonrefundable credit.
Observation: Qualified net income includes the “pro rata share or distributive share” of an electing partner’s income. In certain instances, guaranteed payments may not be considered “pro rata share or distributive share” of income for federal income tax purposes, leaving the open question as to whether guaranteed payments may be respected as qualifying income. California Code of Regulations section 17951-4(d)(2), related to the apportionment of business income for nonresidents, provides that “the source of guaranteed payments received by a nonresident partner from a partnership shall be determined as if the guaranteed payments were a distributive share of partnership business income.” Based on this precedent, as well as the mixed federal authority on whether a guaranteed payment is “distributive income,” it appears that the California taxing authorities would respect the inclusion of such guaranteed payments in the net income subject to the PTE tax. Further, because this position would be revenue-neutral for the state, California taxing authorities may not want to challenge this position, but additional guidance would be needed for certainty on this point.
Partners of a qualified entity that elect into the PTE tax are entitled to a credit against their California income tax. The credit is equal to 9.3% of the qualified taxpayer’s pro rata share or distributive share of the qualified net income subject to the PTE tax. In the case where the allowable credit exceeds the individual’s net tax due, the excess is allowed as a carryover to the following five tax years.
Observation: The nonrefundability of the credit under California’s legislation may make the election disadvantageous for those taxpayers that have other state tax credits to offset their liability or losses from other activities/investments, which may make utilization of the PTE credit a challenge. Taxpayers need to consider their own tax profile to determine whether the federal benefit is worth the cost of potentially unusable credits, which means taxpayers will need to model out the benefits of the PTE credit before opting into the PTE regime.
Observation: There is an open question at the federal level as to whether the SALT tax deduction can be specially allocated to each partner based upon their contribution to the elective tax (i.e., matching the credit they are entitled to under A.B. 150) or whether the federal tax deduction must be allocated on a pro rata basis. IRS Notice 2020-75 references qualifying taxes that are reflected as a part of "a partner's or S corporation shareholder's distributive or pro-rata share...." Generally, for federal purposes, a special allocation of the tax expense by a partner would be deemed a separately stated item - not a distributive or pro-rata share. This leaves open the question as to whether a special allocation of the entity-level tax expenses would be respected based on the language of the Notice.
With the ability of qualified taxpayers to elect into the California PTE tax, and with the different sourcing treatment of resident and nonresident PTE income, as discussed above, there could be uncertainty around the deductibility of the tax upon special allocation of the tax expense for federal income tax purposes. An example of why this may present an operational issue is presented below:
Example: Partnership A, a limited partnership, carries on business both within and without California. Partnership A is owned by one California resident partner and one nonresident of California. Each partner receives distributive shares equal to 50% of Partnership A’s income. Partnership A’s pass-through entity taxable income is $2,000,000. Partnership A’s apportionment percentage to California is 10%.
- Resident partner’s taxable income = $1,000,000 (as a resident partner, the full $1,000,000 will be taxable in California).
- PTE Tax Calculation under A.B. 150: $1,000,000 * 9.3% = $93,000.
- Nonresident partner’s taxable income = $100,000 (as a nonresident partner, only 10% of the $1,000,000 attributable to the nonresident partner is taxable in California).
- PTE Tax Calculation under A.B. 150: $100,000 * 9.3% = $9,300.
- A pro rata split of the expense would be $51,150 (50% split between each partner) absent special allocation.
- If special allocation of the entity level tax expenses would be respected for federal income tax purposes, then $93,000 would be specially allocated to the resident partner and $9,300 would be specially allocated to the nonresident partner.
Observation: To address this open question, taxpayers in other states with similar PTE apportionment regimes have considered creating separate entities that only include resident partners. As discussed above, the business purpose and other administrative challenges of such special-purpose entities should be considered before forming such entities.
An irrevocable election may be made by the PTE on an original, timely filed tax return. The Franchise Tax Board has not yet prescribed the method in which qualified partners make an election to have their qualified income included in the PTE tax base.
For tax years beginning on or after January 1, 2021 and before January 1, 2022, the PTE tax will be due and payable on or before the due date of the qualified entity’s original return without regard to any extension of time for filing the return (March 15, 2022 for calendar-year taxpayers).
For each tax year beginning on or after January 1, 2022, and before January 1, 2026, the elective tax is due and payable as follows:
A. On or before June 15 of the tax year of the election in an amount equal to or greater than either (1) 50%t of the elective tax paid the prior taxable year, or (2) $1,000, whichever is greater.
B. On or before the due date of the qualified entity’s original return without regard to any extension of time for filing the return in an amount equal to the amount equal to the elective tax due less the payment made on or before June 15 (as referenced in subparagraph A).
While California legislators had the opportunity to provide taxpayers with an expansive elective PTE in line with other states with similar PTE taxes, the legislation is somewhat limited in potential benefit. Based on the limitations discussed above, it would be prudent for taxpayers interested in electing into the tax to consider the benefit of electing into the PTE for a given tax year or structure its business in a way to allow the entity to increase the benefit of the available California PTE tax.
Partner, State and Local Tax Financial Services Leader, PwC US