T +1 415 354 4798
T +1 408 346 4325
T +1 415 318 2298
T +1 408 346 4319
Jamie C. Yesnowitz
T +1 202 521 1504
T +1 312 602 8517
T +1 513 345 4540
T +1 215 814 1743
On July 16, 2021, California Gov. Gavin Newsom signed Assembly Bill 150 (A.B. 150) which contains the “Small Business Relief Act” creating an elective pass-through entity (PTE) level tax available to certain qualified entities, and a PTE tax credit available to certain qualified taxpayers.1
A.B. 150 makes California the latest in a wave of states that has adopted similar PTE tax regimes designed to circumvent the $10,000 federal cap on the deductibility of state taxes adopted by the Tax Cuts and Jobs Act of 2017 (TCJA).2
In addition to the Small Business Relief Act, A.B. 150 also contains provisions relating to tax credits, sales and use tax exemptions, and data sharing laws.
California’s new elective PTE tax regime
Under the Small Business Relief Act, for tax years beginning in 2021 through 2025,3
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%.4
When this election is made, a PTE owner that is a “qualified taxpayer” is allowed a credit against its California income tax liability as computed under California’s ordinary tax rate structure.5
Any unused credit may be carried forward for up to five years.6
Concerning the application of California’s elective PTE tax, A.B. 150 specifies that any tax paid under the Small Business Relief Act is in addition to, and not in place of, any other tax requirements that may be imposed upon the individual or corporate owners of the PTE.7
As a result, it is anticipated that owners of an electing PTE that are “qualifying taxpayers” will still need to file California returns and claim the corresponding tax credit for amounts paid on their behalf at the PTE level.
The provisions of the Small Business Relief Act generally remain in effect until December 1, 2026, when they will be repealed.8
However, if Internal Revenue Code (IRC) Sec. 164(b)(6), as it read on January 1, 2021, is repealed prior to December 1, 2026, then the PTE election provisions automatically become inoperative at the beginning of the calendar year following the date that IRC Sec. 164(b)(6) is repealed, and is repealed on December 1 of that tax year.9
Qualified entity election eligibility
A flow-through entity (i.e., S corporation, limited liability company, limited liability partnership, or limited partnership) can elect to pay this tax in a covered year where it is considered a “qualified entity,” which is defined as any entity that is both: (i) taxed as a partnership or S corporation; and (ii) all of the entity’s partners, shareholders, or members are either corporations or taxpayers as defined in Cal. Rev. & Tax. Code Sec. 17004 excluding partnerships
The definition of “qualified entity” also explicitly excludes any publicly traded partnership, and any entity that is part of a corporate combined reporting group, as defined by Cal. Code Regs. tit. 18, Sec. 25106.5(b)(3).11
For tax years beginning in 2022 through 2025, to make a valid 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 $1,000.12
If this payment requirement is not met, the PTE will not be eligible to make the election.13
For tax years beginning in 2021, the aforementioned payment requirement is not required and the PTE tax is due and payable on or before the original return due date, without regard to any extension.14
For tax years beginning in 2022 through 2025, a similar final PTE tax payment is due on or before the original return due date, less the estimated tax payment made on or before June 15 of the taxable year.15
If the previously described payment requirements are met, the irrevocable election to pay the PTE-level tax is made annually and can only be made on a timely filed original return for the taxable year.16
Once the election is made, an owner’s pro rata share of income is included in the entity-level tax computation upon the owner’s consent and taxed at a rate of 9.3%.17
An owner that does not consent does not prevent the qualified entity from making the election.18
Since the form and manner of the election and owner consent have not been prescribed to date, further guidance and regulations are likely to be issued by the California Franchise Tax Board (FTB).19
Other items included in budget legislation
In addition to the Small Business Relief Act, A.B. 150 contains several other tax-related items, including:
- State Historic Tax Credit: Extends the current credit for an additional year, to apply to tax years beginning in 2021 through 2026.20
- Main Street Hiring Credit: Expands an existing tax credit for small businesses that hire new employees.21
- Homeless Hiring Credit: Creates a tax credit for employers who hire homeless individuals for tax years beginning in 2022 through 2026.22
- Donated Fresh Food Tax Credit: Extends the current credit for an additional five years, to apply to tax years beginning in 2017 through 2026.23
- California Competes Tax Credit: Increases the aggregate amount of allocable credit in FY 2021-22 under the California Competes Tax Credit Program from $180 million to $290 million.24
- Diaper and Menstrual Product Sales Tax Exemption: Indefinitely extends the exemption from sales and use tax for diapers and menstrual products.25
- Medi-Cal Data Sharing: Allows the State Department of Health Care Services to exchange data with the FTB.26
For tax years beginning in 2018 through 2025, the TCJA amended IRC Sec. 164 to limit the deductibility of state taxes to $10,000 for individuals, but imposed no similar limitation on business entities.27
With the enactment of A.B. 150, California has joined a growing trend among states that have enacted entity-level taxes for PTEs as a mechanism to bypass the federal $10,000 SALT deduction limitation on individuals provided in the TCJA.28
By its own terms, California’s new elective PTE tax regime is in addition to any other tax filings required for individuals, corporations, or other types of owners.29
Therefore, unlike some other states that have attempted to have the PTE tax stand in the place of other filings,30
California’s elective tax does not appear to simplify or replace the filing obligations that PTE owners may otherwise have. Notably, the tax rate used to calculate California’s elective PTE tax is a flat rate of 9.3%, which is substantially lower than California’s current highest marginal individual income tax rate of 13.3%. Conceivably, this means that an individual owner of an electing PTE may have additional income tax due after application of the credit for taxes electively paid at the entity level. Additionally, nonresident individuals will need to consider whether their state of residence will provide an income tax credit for their distributive share of PTE-level income taxes electively paid to California in the event an election is made. The non-refundability of the credit that the PTE owner will receive means that the potential benefit of the elective PTE-level tax may vary based on the profile of each owner. For example, the presence of other unrelated California income tax credits or net operating losses from activities unrelated to PTE ownership could potentially lead to the carryover (and potential expiration) of unused credits.
Certain nuances of A.B. 150 should be closely monitored by owners of PTEs considering whether to elect to pay tax at the entity level. For example, to be eligible to make the election, the “qualified taxpayers” within the PTE’s ownership structure can be either corporations, individuals, fiduciaries, estates, or trusts, but cannot
be other entities taxed as partnerships. This would appear to disqualify tiered PTE structures from making the election. Also, an entity that is disregarded for federal income tax purposes is excluded from the definition of a “qualified taxpayer” eligible to claim a credit for PTE taxes electively paid.31
Additionally, careful attention will need to be paid to the estimated payment requirements included in A.B. 150 as a precondition to the ability to make the PTE tax election. For 2021, there is no estimated payment requirement, but the entire tax must be paid by the due date of the original return. Beginning in 2022, in order to qualify to make the election on an original return, an estimated payment must be made by June 15 of the taxable year of the election based on the greater of 50% of the prior year’s elective tax paid or $1,000.32
This requirement may be easily overlooked if the entity does not properly plan for the election and could render the PTE ineligible to make the election.
The sunset provision of the California’s PTE tax is mirrored by IRC Sec. 164(b)(6), both of which are to automatically expire for tax years beginning after 2025. Although A.B. 150 is clear that California’s elective PTE tax will automatically be repealed should IRC Sec. 164(b)(6) be repealed before the beginning of 2026, it is less clear what may happen if IRC Sec. 164(b)(6) is modified in any way without being repealed. Should the federal $10,000 SALT deduction limitation be increased, decreased, or extended without being repealed, California may need to provide additional guidance as to the impact on the elective PTE tax regime set forth in the Small Business Relief Act.
A.B. 150 also directs that the FTB may adopt regulations that are necessary or appropriate to implement the Small Business Relief Act,33
and it is anticipated that additional guidance will be issued by the FTB regarding the forms and procedures for making an election.
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.