Co-authored by Mark Lobb & Braden Lobb
California has taken a welcome step towards allowing certain business owners to mitigate the effects of the $10,000 federal limit on the SALT deduction limitation implemented under the Tax Cuts and Jobs Act.
On July 16, Governor Newsom signed into law Assembly Bill 150 (the “Bill” or “AB-150”). The Bill allows certain pass-through entities to elect to pay California income tax on behalf of their individual, estate, and trust owners. If so elected, the entity takes the deduction for the state tax paid without limit. This reduces the federal taxable income passed through to the owners. In turn, the owners receive a California income tax credit for the tax paid by the entity that avoids the same income being taxed twice. The IRS acknowledges the legitimacy of this elective entity-level state tax work-around in IRS Notice 2020-75.
AB-150 is effective for tax years beginning January 1, 2021, for a “Qualified Entity” which elects to pay California income tax on behalf of its owners at a rate of 9.3% on its California sourced income for years beginning in 2021 through 2025. A “Qualified Entity” is defined as (1) an S-corporation or an entity taxed as a partnership, such as a multi-member limited liability company, whose owners are (2) individuals, corporations, trusts, and estates. A pass-through entity with one ineligible owner is disqualified. In the past, we have used general partnerships to act as non-member managers which is fine, but if a partnership is a member, the entity will not be deemed qualified. We need to be careful with our ownership structures.
The following ten points should be noted:
- S-corporations and their owners should be cautious of not uniformly opting into such an election. A split by shareholders in opting into the election may create a “second class of stock” under the S-corporation rules. This in turn will invalidate S-corporation status.
- California residents in tax brackets lower than 9.3% or who expect their California net taxable income to be lower than realized at the electing entity level may choose to opt out.
- AB-150 does not prevent a Qualified Entity from electing to pay the entity-level tax when one or more of its owners fail to consent to the election. Nonconsenting owners share of the entity’s income is not be subject to the entity-level tax. The entity simply does not allocate any California tax credit to the nonconsenting owners.
- It is imperative to determine if a nonresident client has the ability to use the California tax credit. If a non-resident does not have the ability use the California tax credit to offset state taxes owed to their resident state, they should be advised not to consent.
- AB-150 does not limit the type of business that can make the election. It applies to any business with California source taxable income. There are no active trade or business status requirement on qualification as an Eligible Entity. Some states have restricted the benefit of the work-around to source active trade or business income, but such a requirement is not in the California Bill.
- A Qualified Entity must elect to pay the entity-level tax on its timely filed California income tax return for each year, under guidance to be provided by the FTB. Failure to timely pay the entity-level tax for a given year disqualifies an entity from electing for such year.
- For tax years beginning in 2021, the Qualified Entity has until the due date of the original return, excluding extensions to pay the entire entity-level tax. So, the due date for calendar-year entities is March 15, 2022. For tax years beginning in 2022, the entity must pay a first installment by June 15 of the applicable tax year equal to the greater of (1) 50% of the prior year’s California entity-level elective tax or (2) $1,000. The second installment payment of the entity-level tax for the remainder of the applicable tax year must be made by the due date of the entity’s return for such tax year, excluding extensions which will be March 15, 2023 for tax year 2022.
- Any excess credit amount is carried forward for up to five years. It is unclear whether such carryforwards will expire when the SALT work-around sunsets after 2025.
- There are many restructuring considerations. It may be desirable for C-corporations to make an S-election. Sole proprietors may wish to form an LLC and add a member to be a regarded entity or incorporate as an “S” corporation.
- There are many ancillary considerations. S-corporations are required to pay reasonable compensation to shareholders for services rendered. Such compensation reduces the entity’s net income subject to the elective tax. Guaranteed payments may be deemed compensation for services and not pass-through income. There is no guidance on guaranteed payments.
In the coming months there will be guidance on the tax election by the FTB. Taxpayers should consider amending shareholder and operating agreements to set forth protocols for making the election, obtaining “consent,” and other issues relative to the implementation. Certain LLCs along with corporations should also document the election and protocols through appropriate board resolutions.