California amends elective pass-through entity tax

On Feb. 9, 2022, California Gov. Gavin Newsom signed Senate Bill 113 (S.B. 113)¹ making important amendments to California’s elective pass-through entity (PTE) tax regime, which previously was created by the Small Business Relief Act (SBRA) last year.² S.B. 113 modifies the SBRA in several important ways, including: (i) broadening the definition of an “electing qualified entity” to include those that themselves have an owner that is taxed as a partnership; (ii) amending California’s credit ordering rules to address the ordering of the PTE tax credit relative to other credits; (iii) providing that the PTE tax credit can be applied to reduce tentative minimum tax (TMT); and (iv) specifying that guaranteed payments are included in qualified net income for purposes of computing the PTE tax due for a qualified electing entity.

S.B. 113 also contains an accelerated sunset to the net operating loss (NOL) deduction suspension and the business tax credit limitation that California enacted in 2020.³ As a result of S.B. 113, the original three-year NOL suspension and credit limitation period (2020 through 2022) has been shortened by one year and does not apply to taxable years beginning in 2022.

PTE tax amendments

Under the SBRA, for tax years beginning in 2021 through 2025,⁴ a PTE that is a “qualified entity” may make an annual election to pay tax at the entity level on “qualified net income” at a rate of 9.3%.⁵ When this election is made, a PTE owner that is a “qualified taxpayer” is allowed an income tax credit against California income tax liability based on 9.3% of the owner’s income that was included in the qualified net income of the electing PTE by consent. To the extent unused by the qualified taxpayer, the credit for the PTE tax can be carried forward for up to five years.⁶ Some of the more noteworthy changes to the SBRA made by S.B. 113 are summarized below.

Changes to definition of “qualified entity” and “qualified taxpayer”

As originally enacted, the SBRA defined a “qualified entity” as one that meets two requirements. First, the entity must be taxed as a partnership or S corporation,⁷ and second the entity’s partners, shareholders, or members must all be corporations or taxpayers as defined in Cal. Rev. & Tax. Code Sec. 17004, excluding partnerships.⁸ For tax years beginning on or after Jan. 1, 2021, and before Jan. 1, 2026,⁹ S.B. 113 broadens the definition of a qualified entity by amending Cal. Rev. & Tax. Code Sec. 19902 to delete the reference to “excluding partnerships,” thereby enabling PTEs with partnership owners to potentially be a “qualified entity.”¹⁰

Under the original language of the SBRA, a “qualified taxpayer” for purposes of claiming the PTE tax credit excluded an entity disregarded for federal tax purposes (e.g., a single member limited liability company (LLC)).¹¹ For tax years beginning on or after Jan. 1, 2021, and before Jan. 1, 2026,¹² S.B. 113 amends the “qualified taxpayer” definition to provide that the exclusion of an entity disregarded for federal tax purposes “shall not apply” to an LLC that is disregarded federally if two requirements are met: (i) it is owned by a taxpayer as defined in Cal. Rev. & Tax. Code Sec. 17004, excluding partnerships, that consented to have their guaranteed payments and their pro rata share or distributive share of income subject to tax under the state’s PTE tax regime; and (ii) it is a partner, shareholder, or member of an “electing qualified entity.”¹³

Updates to tax credit ordering rules

Under the original language of the SBRA, there was significant concern that the income tax credit to the “qualified taxpayer” allowed by Cal. Rev. & Tax. Code Sec. 17052.10 would be applied before any credits for net income taxes paid to other states (described in Cal. Rev. & Tax. Code Sec. 18001), which have no carryover provision. Under this original structure, in the event that the PTE tax credit utilization would render the later applied other state tax credit unnecessary, the other state tax credit would simply expire without any carryover. To address this concern, for tax years beginning on or after Jan. 1, 2022, S.B. 113 amends California’s credit ordering statute, Cal. Rev. & Tax. Code Sec. 17039, to provide that PTE tax credits described in Cal. Rev. & Tax. Code Sec. 17052.10 will be taken into account after any other state tax credits allowed by Cal. Rev. & Tax. Code Sec. 18001.¹⁴

PTE tax credit allowed against tentative minimum tax

In general, personal income tax credits cannot reduce the “net tax,” as defined by Cal. Rev. & Tax. Code Sec. 17039(a), below the TMT unless the credit is among those specifically enumerated under Cal. Rev. & Tax. Code Sec. 17039(c)(1). Because the original language of the SBRA did not specifically identify the PTE tax credit provided in Cal. Rev. & Tax. Code Sec. 17052.10 as one that is able to offset the TMT under Cal. Rev. & Tax. Code Sec. 17039(c)(1), significant concern existed that the PTE tax credit may be unusable for qualified taxpayers owing TMT in excess of regular tax, which could in turn discourage many PTE owners from consenting to have their income included in the qualified electing entity’s qualified net income subject to tax. To remedy this issue, for tax years beginning on or after Jan. 1, 2021, S.B. 113 amends Cal. Rev. & Tax. Code Sec. 17039(c)(1) to allow the PTE tax credit described in Cal. Rev. & Tax. Code Sec. 17052.10 to be applied to reduce the TMT.¹⁵

Qualified amount now includes guaranteed payments

Under the original language of the SBRA, the “qualified net income” of a qualified entity making the PTE tax election (to which the 9.3% PTE tax rate is applied) did not include guaranteed payments. As amended by S.B. 113, for tax years beginning on or after Jan. 1, 2021, and before Jan. 1, 2026, the “qualified net income” of the electing PTE and the “qualified amount” on which the qualified taxpayer’s PTE tax credit is based both have been amended to include guaranteed payments.¹⁶

Reinstatement of NOL and business tax credit utilization

California enacted A.B. 85 on June 29, 2020, temporarily suspending the utilization of the NOL¹⁷ deduction for most taxpayers and limiting the amount of business tax credits¹⁸ companies may utilize in 2020, 2021, and 2022 to no more than $5 million in each year.¹⁹ S.B. 113 amends the statutory changes enacted by A.B. 85 to shorten the NOL deduction suspension and business tax credit limitation period from three years to two, generally restoring pre-A.B. 85 law on the utilization of NOLs and tax credits in tax years beginning on or after Jan. 1, 2022.²⁰

Commentary

In light of California’s widely reported budget surplus in the 2022 fiscal year, projected to be in excess of $45 billion,²¹ it is encouraging to see certain taxpayer-friendly measures included in S.B. 113. In particular, many companies that incurred losses in 2020 at the beginning of the pandemic will likely welcome the shorter NOL suspension and credit limitation period now applicable under S.B. 113.

In enacting the SBRA in 2021, California joined over 20 other states that have enacted analogous PTE tax regimes to help mitigate the impact of the TCJA’s $10,000 state and local tax deduction cap that took effect in 2018. After the SBRA was enacted by A.B. 150 on July 16, 2021, many commentators noted material gaps in the initial legislation. Most notably, the inability of PTE owners to utilize the California personal income tax credit provided in Cal. Rev. & Tax. Code Sec. 17052.10 against the TMT, and the potential disadvantageous credit ordering that could cause other state tax credits to go unused and automatically expire. California’s legislature has been aware of these shortcomings since 2021 and has moved relatively swiftly to address concerns through the enactment of S.B. 113 in February 2022. The amendments to the SBRA in S.B. 113 are particularly timely because for calendar year PTEs considering the PTE tax election for the 2021 tax year, payment of the PTE tax is due by March 15, 2022 (the original due date of the entity’s tax return determined without regard to extensions). Although payment is required by the due date of the entity’s tax return determined without regard to extensions, the election itself is to be made on a timely filed original return, which can be filed on extension.

Interestingly, S.B. 113’s amendment delineating that the other state tax credit provided by Cal. Rev. & Tax. Code Sec. 18001 is to be claimed before any PTE tax credits of a qualified taxpayer under Cal. Rev. & Tax. Code Sec. 17052.10 is only effective for taxable years beginning on or after Jan. 1, 2022.²² No explanation is given in the Legislative Counsel Digest language included with S.B. 113 as to why this particular change has an effective date one year later than other changes to the SBRA made by S.B. 113.

S.B. 113’s updated definition of a “qualified entity” to include those that have a partnership as an owner expands the potential pool of qualified electing entities. The inclusion of IRC Sec. 707(c) guaranteed payments in the credit computation as part of the “qualified amount,” along with the other changes in S.B. 113 addressing the California PTE tax regime may be a catalyst for many additional PTEs to consider and ultimately make the PTE tax election.

Lastly, it is important to keep in mind that for tax years beginning in 2022 through 2025, to be eligible to make the PTE tax election a qualified entity must pay estimated taxes on or before June 15 of the taxable year in an amount that is the greater of 50% of the elective tax paid during the prior taxable year, or $1,000.²³ If this payment requirement starting in 2022 is not met, the PTE will not be eligible to make the election.²⁴ For those qualified entities that make the PTE election for 2021, the amount paid by the original return due date (without regard to extensions) is likely to dictate the amount due by June 15, 2022 to be eligible to make the PTE tax election in 2022. Because this payment requirement may be easily overlooked, entities considering the election are encouraged to properly plan for any estimated payments required to be eligible for the election.