California’s Workaround to the Federal Cap on State Tax Deductions
By: Matt Sapowith and Nolan Shutler
On July 16, 2021, California joined a growing number of states that have enacted workarounds to the $10,000 limitation on the federal deduction for state and local taxes (SALT). California’s approach is to permit eligible pass-through entities to annually elect to pay a special tax (at a 9.3% flat rate) on the income allocable to certain participating owners of those entities (the “PTE Tax”) and then to claim the related tax payments as a business deduction. The result is that participating owners receive a potentially larger deduction for state taxes on their federal tax returns and a tax credit equal to their share of PTE Tax paid on their California state tax returns.
California’s workaround is in effect for the 2021 tax year and will continue to be available through the 2025 tax year (although it could expire earlier if the federal $10,000 limitation is repealed by Congress prior to its current sunset date of January 1, 2026).
The state tax credit, which is nonrefundable, can be carried over for five years. Nonresidents and part-year residents do not have to prorate the credit to account for their non-California income.
How to Elect
California’s workaround is available for partnerships (including those structured as LLCs) and S corporations that only have individuals, trusts, estates, and/or corporations as owners. Publicly traded partnerships, partnerships owned by other partnerships, members of a combined reporting group, and disregarded entities do not qualify. (Disregarded Single-Member LLCs are not eligible to make the election, but will not make the entity ineligible if they are an owner of an otherwise eligible PTE).
Not all the owners of the pass-through entity need to consent to the election. Those that do not consent are not included in the calculation of the PTE Tax. To take advantage of the workaround, the pass-through entity needs to make the election annually on its state tax return. In addition, payments towards the PTE Tax need to be made by specified due dates.
• For the 2021 tax year, 100% of the PTE Tax needs to be paid by the due date for the pass-through entity’s state tax return without extensions – March 15, 2022.
• In later years, the PTE tax needs to be paid in two installments: the first installment is due by June 15 of the tax year for which the election is being made, and the second installment is due by the due date for the pass-through entity’s state tax return for that tax year without extensions (i.e., the following March 15). The minimum amount for the first installment is $1,000.
What to Consider
The biggest benefit to the owners of a pass-through entity is the ability to claim a federal tax deduction for their share of the pass-through entity’s state income tax paid to California, but there is another potential benefit. In future years (starting with the 2022 tax year) PTE Tax payments may create some “float” for the owners in terms of the timing and amount of their individual estimated tax payments:
• Individuals in California need to pay 70% of their estimated tax liability through quarterly payments on April 15 and June 15, while the PTE Tax only requires that one installment of 50% of the total tax be paid in by June 15.
• Individuals in California need to pay the remaining 30% of their estimated tax liability by January 15 of the following year (i.e., the 4th quarter payment), while the PTE Tax only requires the remaining 50% be paid in by March 15.
However, despite these benefits, other factors should be considered before making the election:
• If the pass-through entity provides most of the income for an owner and that owner’s top California tax rate is less than or equal to 9.3%, the state tax credit cannot be used in full before it expires. On the other hand, since the election is made annually, you could avoid accruing too much carryover by opting not to elect in a following year.
• It’s unclear how California’s workaround will interact with pass-through entity tax regimes enacted by other states, especially their associated state tax credits. California provides credits against most other states’ taxes, but guidance has not been provided to indicate that it will afford the same treatment to other state PTE Taxes paid. Multi-state operators may not be able to reduce California taxable income by the amounts of other states’ similar taxes.
• The 9.3% flat rate may not be sufficient to cover the full tax liability for higher income owners.
• The PTE tax credit does not reduce the amount of tax due below California’s Tentative Minimum Tax (TMT), and thus may not be as beneficial for taxpayers subject to the TMT.
• There are considerations pertaining to cash management, since the pass-through entity would be paying the PTE Tax, not the owners.
• Non-resident withholding (7% for individuals) is not offset by the withholding requirements for the PTE Election. Non-resident taxpayers making the election would therefore be required to pay in tax at 16.3% among the quarterly and bi-annual installments, then claim a refund up to the amount of the 7% withholding. But because the 9.3% PTE Tax is non-refundable, to the extent that withholding exceeds tax due, it would need to be claimed in a later year.
How we can help
This PTE Election is a little complicated, but it is worth the effort to explore. MGO’s state and local tax professionals can advise you on the numerous pass-through entity tax regimes being passed by states to counter the federal limitation on deducting state taxes. Our cumulative experience as SALT specialists can help you determine if you are able to benefit from pass-through entity taxes and how to appropriately use them. Reach out to our team of experienced practitioners for your state and local tax needs.