Introduction
In an effort to mitigate the impact of the $10,000 federal cap on state and local tax (SALT) deductions imposed by the Tax Cuts and Jobs Act (TCJA) of 2017, California has introduced an elective pass-through entity (PTE) tax for tax years beginning in 2021 through 2025. This initiative aims to provide a workaround that allows eligible pass-through entities to pay state taxes at the entity level and deduct these payments for federal purposes, while offering a tax credit to the entity owners for state tax purposes. The Pass-Through Entity (PTE) Tax in California allows eligible pass-through entities to pay state taxes at the entity level and provides a tax credit to owners to mitigate the federal cap on state and local tax deductions.
This article delves into the specifics of California’s PTE tax, exploring its eligibility criteria, election process, tax payment schedules, calculation methods, and potential implications for taxpayers.
Related: How to Incorporate a Small Business in California?
Eligibility Criteria for the PTE Tax Election
Qualified Entities
To make the election, an entity must be taxed as a partnership or S corporation and have only the following as partners, shareholders, or members:
- Corporations
- Individuals
- Fiduciaries
- Estates
- Trusts
Non-Qualified Entities
Entities that do not qualify include:
- Entities with a partnership as a partner, shareholder, or member
- Publicly traded partnerships
- Entities required or permitted to be included in a combined report
A disregarded entity can be part of a qualifying entity if the entity meets other requirements. However, a disregarded entity alone cannot qualify as it is not taxed as a partnership or S corporation.
Election Process and Irrevocability
Making the Election
Eligible entities must make the election annually on an original, timely filed tax return. Once the election is made, it is irrevocable for that tax year. This irrevocability underscores the importance of careful planning and consideration before making the election.
Tax Payment Schedule
Initial Payment Deadlines
For the 2021 tax year, the tax is due by the original due date of the entity’s tax return, without regard to extensions.
Subsequent Years Payment Schedule
For tax years 2022 through 2025, the tax is due in two installments:
- By June 15 of the tax year, at least 50% of the elective tax paid in the prior year or $1,000, whichever is greater.
- By the original due date of the entity’s tax return (without regard to extensions), the balance of the tax due.
Payments must be made using Form 3893, Pass-Through Entity Elective Tax Payment Voucher. Failure to make the first payment by June 15 disqualifies the entity from making the election for that tax year.
Tax Calculation and Qualified Net Income
Tax Rate and Calculation Method
The PTE tax is imposed at a rate of 9.3% on the entity’s qualified net income. This tax is in addition to any other applicable taxes or fees. The Franchise Tax Board is developing Form FTB 3084, Pass-Through Entity Elective Tax Calculation, to aid in this process.
Definition of Qualified Net Income
Qualified net income is defined as the sum of the pro rata or distributive shares of income subject to California personal income tax of each qualified taxpayer.
Example of PTE Election
Consider ABC Tech LLC, a partnership with two equal partners and a qualified net income of $200,000. If both partners make the PTE election, the partnership pays a PTE elective tax to the California Franchise Tax Board. Each partner will report $90,700 of net income on their federal K-1. On their California returns, they will report $100,000 of net income from ABC Tech LLC and a tax credit of $9,300 against their individual California income tax.
Qualified Taxpayer Criteria
Who Qualifies?
A qualified taxpayer is an individual, fiduciary, estate, or trust subject to California personal income tax that:
- Is a partner, shareholder, or member of an electing entity.
- Consents to have their pro rata or distributive share of income subject to tax included in the qualified net income of the electing entity.
Exclusions
Qualified taxpayers do not include:
- Disregarded business entities or their partners or members.
- Corporations.
- Partnerships.
A partner, shareholder, or member who does not consent to their share of income being included in the qualified net income does not prevent the entity from making the election.
Claiming the Tax Credit
Personal Income Tax Credit
Qualified taxpayers may claim a personal income tax credit for their share of the tax paid. This credit is nonrefundable but can be carried over for up to five years. Taxpayers must use Form FTB 3804-CR, Pass-Through Entity Elective Tax Credit, to claim the credit.
Implications for Non-Resident Shareholders
For non-resident shareholders, members, or partners, the credit applies only to California-sourced income. This distinction is crucial for entities with diverse ownership structures.
Potential Complications and Considerations
Non-Resident Shareholders
Entities with non-resident shareholders must be cautious, as the credit only applies to California-sourced income. This can create complexities in the tax treatment for non-resident owners.
S Corporations and Distributions
S corporations must ensure that they make compensating distributions for non-qualified shareholders when making the election for other qualified shareholders to avoid jeopardizing their S corporation status.
High K-1 Income Considerations
Recent legislation (California law SB 113) allows the PTE tax credit to reduce the tentative minimum tax. This change is significant for qualified taxpayers with high K-1 incomes, who previously might not have benefited from the PTE elective tax credit.
Expiration and Future of the PTE Tax
Expiry Date
California’s elective PTE tax is set to expire after the 2025 tax year. However, it will be repealed sooner if the $10,000 SALT deduction limitation in IRC Sec. 164 is repealed.
Future Considerations
Taxpayers and tax professionals should remain vigilant about potential legislative changes that could impact the PTE tax framework. Given the dynamic nature of tax laws, staying informed is essential for maximizing tax benefits.
Conclusion
California’s elective PTE tax offers a strategic workaround to the federal SALT deduction cap, providing significant benefits to eligible pass-through entities and their owners. By understanding the eligibility criteria, election process, tax payment schedules, and potential complications, taxpayers can make informed decisions to optimize their tax positions. As with any tax-related decision, consulting with a tax professional is highly recommended to navigate the complexities and maximize the advantages of this elective tax.
