California has revised its existing SALT cap work-around to address and liberalize several of the significant limitations on the work-around that we discussed in our prior alert.
On February 9, Governor Gavin Newsom signed into law Senate Bill 113 ("SB-113"), which amended provisions of the SALT cap work-around to make them more favorable to taxpayers, together with enacting other tax benefits. As described in our prior alert, the SALT cap work-around allows certain pass-through entities ("PTEs") to elect to pay, on behalf of their individual, estate, and trust owners with their consent, a California income tax on PTE income at a rate of 9.3% ("PTET"). If so elected, the PTE takes the deduction for the state tax paid without limit, reducing the federal taxable income passed through to the owners. Those owners receive a California income tax credit ("PTET Credit") for the tax paid by the entity, which is intended to offset each owner's California tax liability with respect to their share of such income and thereby avoid the same income being taxed twice.
The amendments that SB-113 made to provisions of the SALT cap work-around are as follows:
First, the PTET Credit can be used to effectively reduce the tax liability of some PTE owners below their alternative minimum tax ("CA AMT") liability. Before the enactment of SB-113, the PTET Credit was not included in a list of tax credits that were allowed to reduce a PTE owner's tax liability below the 7% tentative minimum tax. SB-113 added the PTET Credit to this list of tax credits. This change increases the potential tax benefit of the PTET Credit for some PTE owners who are subject to CA AMT.
Second, guaranteed payments that PTEs make to a PTE owner can be included along with the PTE owner's pro rata shares or distributive shares of the PTE's income in establishing the tax base against which the PTET is applied. Guaranteed payments, as defined in U.S. Internal Revenue Code Section 707(c), are frequently made by PTEs taxed as partnerships to their partners who provide services to the partnership. Guaranteed payments generally are deductible in determining a partnership's taxable income that flows through to its partners. Before the enactment of SB-113, guaranteed payments would reduce partnership income that would be subject to the PTET and thus reduce the PTET Credit. The exclusion of guaranteed payments from the PTET tax base significantly reduced PTET coverage for partnerships that characterized much of their earnings as guaranteed payments. The inclusion of guaranteed payments in the PTET tax base may substantially increase the tax benefits of a PTET election for such partnerships and their partners.
Third, a PTE that has a partnership as an owner will not be precluded from making a PTET election. Before the enactment of SB-113, a PTE that had a partnership as an owner was not eligible for a PTET election. This change will make the PTET election available for more PTEs. SB-113 does not, however, allow an electing PTE to include a distributive share of its owners that are partnerships in the PTET tax base, and such partnership owners will not be entitled to claim any PTET Credit with respect to a PTET paid by the electing PTE.
Fourth, the pro rata share or distributive share of an electing PTE's income attributable to owners that are single member limited liability companies (characterized as disregarded entities for income tax purposes) may be included in the PTET tax base. The single member limited liability company may claim a corresponding PTET Credit. However, a single member limited liability company cannot itself make the PTET election.
All four of the above changes are effective beginning with the 2021 tax year and thus can be applied on returns for 2021 now in the process of being prepared and filed.
Fifth, effective for tax years beginning on or after January 1, 2022, the PTET Credit is applied after California's other state tax credit ("OSTC") in calculating tax liability. This placement may benefit some taxpayers who have both OSTCs and PTET Credits. OSTCs have to be used for the year that the taxes are paid, but PTET Credits can be carried forward to the following five tax years. Placing the PTET Credits after OSTCs allows for more OSTCs to be used in the only tax year that they are available. Accordingly, when considering whether to a make a PTET election for 2022 and later years, consideration should be given to whether this ordering of the credits will adversely affect the ability to use PTET Credits for the current year and over their five-year carryforward period, given expectations regarding the availability of OSTCs for those years that will be applied before the PTET Credits. SB-113 also removed a limitation on the use of tax credits (including PTET Credits) to reduce a tax liability by more than $5,000,000 that was previously in effect for tax years commencing on a date falling between January 1, 2022 and December 31, 2022.
Legislation remains pending in Congress that would increase or otherwise alter the SALT cap. Whether any such legislation will be enacted remains uncertain. If enacted, any such changes to the federal cap could significantly affect the analysis of whether particular state SALT cap work-arounds are worthwhile. In any such analysis, consideration should also be given to the impact of the federal alternative minimum tax.
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.