While Congress has stalled on passing legislation that would eliminate, in whole or in part, the current limit on an individual taxpayer's ability to take the itemized deduction for state and local taxes, California has taken a dramatic step toward allowing many of its residents to mitigate the effects of the $10,000 federal limit on that deduction implemented under the Tax Cuts and Jobs Act.
On July 16, Governor Gavin Newsom signed into law Assembly Bill 150 (AB-150), which includes a mechanism for certain pass-through entities to elect to pay California income tax on behalf of their individual, estate, and trust owners with their consent. If so elected, the entity takes the deduction for the state tax paid without limit, reducing the federal taxable income passed through to the owners, and the owners receive a California income tax credit for the tax paid by the entity that avoids the same income being taxed twice. The benefits could be massive for pass-through entity owners who can take advantage of this work-around. Moreover, as we noted in our prior post regarding an earlier proposed version of the elective tax, the IRS surprisingly has blessed these elective entity-level state tax regimes in IRS Notice 2020-75. While AB-150's elective tax work-around appears quite favorable to California residents, the devil is always in the details, which we address below.
Eligible Entities and Owners
Under AB-150, effective for tax years beginning January 1, 2021, a "Qualified Entity" can elect annually 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" means (1) an S-corporation or an entity taxed as a partnership, such as a multi-member limited liability company, whose owners are only (2) individuals, corporations, trusts, and estates. Herein lies a key limitation – a pass-through entity with even one ineligible owner is disqualified. To illustrate, consider talent management company ABC that is taxed as a partnership, owned one-third each by Adam (an individual), Bill (an individual), and Partnership CD owned by Chuck and Dan. ABC cannot make the election because it has a partnership owner – not an eligible owner. While Partnership CD can likely elect itself and pay California tax on behalf of Chuck and Dan, Adam and Bill appear to be out of luck with respect to taking advantage of AB-150's elective tax through their ownership of ABC. While the original incarnation of this elective workaround under Senate Bill 104 discussed in our prior post excluded entities with any corporate owners, it appears the final version under AB-150 allows a Qualified Entity to have S-corporation or C-corporation owners.
What is surprising about the harsh result above is that AB-150 does not prevent a Qualified Entity from electing to pay the entity-level tax even when one or more of its owners do not consent to the election. Nonconsenting owners are simply left out of the calculus, as their share of the entity's income will not be subject to the entity-level tax, and the entity would not allocate any California tax credit to the nonconsenting owners. The flexibility not to consent should prove highly beneficial, especially to California nonresidents who may not have the ability use the California tax credit to offset state taxes owed to their resident state. S-corporations and their owners should be wary of not uniformly opting into such an election, however, as doing so may create a "second class of stock" under the S-corporation rules and thereby 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 that realized at the electing entity level may also choose to opt out.
Notably, AB-150 provides no limit on the type of business that can make the election. Ideal candidates for the election include service businesses, such as law firms, accounting firms, management companies, and similar business with California source taxable income. AB-150 does not appear to impose any active trade or business status requirement on qualification as an Eligible Entity. Thus, entities that merely hold a portfolio of passive investments appear to be eligible to elect into the entity-level tax. For example, Maryland has restricted the benefit of its work-around to Maryland source active trade or business income. California has yet to issue guidance that would modify interpretation of the plain language of the legislation.
Timing – Electing and Paying
The 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, however, 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 (i.e., March 15, 2022 for calendar-year entities), to pay the entire entity-level tax. For tax years beginning in 2022, however, the entity must pay a first installment by June 15 of the applicable tax year (i.e., June 15, 2022 for calendar year 2022), 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 (i.e., March 15, 2023 for tax year 2022). For better or worse, it seems that non-calendar-year entities are still bound to the June 15 first installment date.
Tax Credit to Certain Pass-Through Owners
Assuming a Qualifying Entity makes the above election and pays the entity-level tax, certain qualifying owners of the Qualifying Entity are allowed a tax credit in an amount equal to 9.3% of such qualifying owner's share of the Qualifying Entity's California taxable income. Taxpayers eligible to receive this credit are individuals, estates, or trusts. Any excess credit amount is carried forward for up to five years, although it is unclear whether such carryforwards will expire when the SALT work-around sunsets after 2025. Accordingly, owners expecting to be in a lower tax bracket than 9.3% for a given year may consider not consenting to the Qualified Entity's election for such year, to avoid creating a credit carryforward that could expire without providing a benefit.
The elective tax regime provides an additional reason for a C-corporation to make an S-election, provided that all shareholders join in the election, so that the entity's S-corporation status avoids a challenge as having created two classes of shareholders. Similarly, sole proprietors might consider forming an LLC (having a second member so as to treat their business as a partnership for income tax purposes) or incorporating their business and electing S-corporation status. When evaluating any such conversion, a sole proprietor will want to consider the offsetting effects of the fees and taxes that California imposes for having status as partnership or S-corporation for income tax purposes. If the LLC interest is community property, the owner may be eligible to elect to treat the single-member LLC as a partnership owned jointly by spouses holding community property. Additionally, taxpayers should keep in mind the requirement that S-corporations pay reasonable compensation to their shareholders for services rendered, as any such compensation would reduce the entity's net income subject to the elective tax. Unclarity also exists as to whether the elective tax applies to "guaranteed payments" for services paid to owners of entities taxed as partnerships.
Last, the elective entity-level tax under AB-150 expressly repeals itself in the event Congress repeals the $10,000 federal limit – presumably, the AB-150 regime would apply to any California entity-level taxes already paid in by that point. The new law makes no provision for the possibility of Congress modifying the current SALT deduction limit (e.g., increasing the limit or repealing it subject to certain taxable income thresholds), instead of simply repealing the current cap entirely. Thus, those considering the election should continue to watch developments with federal legislation.
The new enabling act for the entity-level tax leaves open a number of questions that, it is hoped, will be addressed as the FTB issues guidance on the tax election implementation. While taxpayers await FTB regulations and updated tax forms and instructions, Qualified Entities considering the election should update their organizational documents to clarify who has the authority to cause the entity to elect and to ensure only consenting owners reap the economic benefits, and take on the burdens, of the elective tax paid by the entity.
The Venable tax team stands ready to guide businesses in evaluating whether they are eligible for the California pass-through entity-level tax, how it will work for them based on their current structure, consideration of potential risks, and what, if any, changes need to be made to an entity's organizational documents to assist with making the tax election.
Updated July 30, 2021.