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January 14, 2021

California proposes a pass-through entity-level tax to provide tax relief to small businesses economically impacted by COVID-19

On January 5, 2021, Democratic members of the California Senate and Assembly introduced a bill (SB 104) that would establish an elective pass-through entity-level (PTE) tax. This new tax on PTEs, if adopted, is intended to enable California taxpayers who are owners of PTEs to deduct, for US federal income tax purposes, state and local taxes that exceed the $10,000 limitation imposed by IRC Section 164 but are consistent with IRS Notice 2020-75.

If enacted, SB 104 would allow qualifying PTEs doing business in California to make an annual election to pay a tax "according to or measured by its net income computed at the rate of ___ upon the basis of its net income for the last preceding taxable year" (elective tax) (the blank in the current version of SB 104 with respect to the PTE tax rate is intentional, with the complications described under Implications).

Gross income of individual partners, shareholders and members (collectively, members1) of qualifying PTEs that make this election would not include the "qualified amount" paid by the qualifying PTE for the tax year.

"Qualified amount" would be defined as "an amount equal to the [member's] pro-rata share of the amount of the elective tax paid by a qualified [PTE] … " A qualifying PTE would mean an entity that meets both of the following:

  • The entity is taxed as a partnership or S corporation under Cal. Rev. and Tax Code Sections 17935 (limited partnerships), 17941 (limited liability companies), 17948 (registered/foreign limited liability partnerships) or 23802 (S corporations).
  • The entity's members in that tax year are exclusively individuals.

The election would be available for tax years beginning on or after January 1, 2021 and before January 1, 2026. A qualifying PTE's decision to make the election would be binding on all of its members.

The elective tax would be due and payable on the original and timely filed return, and would be in addition to any other required personal or corporate income tax.

The provisions enacting the PTE taxes would be effective only until December 1, 2026.


It was anticipated that states would seek to enact PTE-level taxes after the IRS announced (Notice 2020-75) that it will issue proposed regulations clarifying that a partnership or S corporation computing non-separately stated taxable income or loss, for federal income tax purposes, may deduct state and local income taxes imposed on its net income for the tax year at issue (see Tax Alert 2020-2690).2 California is one of the first states to propose such legislation since the IRS's announcement. California Governor Gavin Newsom, on the same day this bill was proposed, previewed his Equitable Recovery for California's Businesses and Jobs plan, which calls for mitigating, for S corporation shareholders, the limitation on the state and local tax deduction. SB 104, however, is more expansive than the Governor's proposal in that it would apply to certain entities taxed as partnerships, in addition to S corporations.

The blank in the current version SB 104 cited previously with respect to the designation of a nominal tax rate is deliberate. If California follows the model for PTE taxes enacted in other states, the rate will likely be equivalent to California's highest marginal personal income tax rate. One complication for California not faced by other states, however, is that the highest marginal tax rate of 13.3% currently applies only to taxpayers with gross income over $1 million. If that rate were adopted, PTE owners whose income falls well below the $1 million threshold would face the possibility of paying much more in state taxes by electing to pay the tax than if no election were made. This might create an incentive for PTE owners to forego the federal tax benefits intended by the measure's proponents.

The proposed bill will likely go through many rounds of edits as it makes its way through the legislative process, which could take weeks or months. Drafting errors in the current version are expected to be fixed during this process, including errors in the definition of "qualified amount," which would reduce a member's income by the amount of tax paid rather than the amount of income that led to the tax being paid, and the tax's expiration date. (The federal limitation on SALT deductions expires for years after December 31, 2025, so it is not clear why the proponents of SB 104 needed to insert a repeal of the PTE tax for periods as of December 1, 2026.)

It is not yet known whether the current list of qualifying PTEs will be expanded to also include general partnerships, in addition to the entity types already listed in the bill. Another critical feature of similar PTE taxes seemingly missing from SB 104 is a mechanism providing California resident taxpayers with a credit for their distributive share of similar PTE taxes paid to other states.


Contact Information
For additional information concerning this Alert, please contact:
State and Local Taxation Group
   • Carl Joseph (
   • Todd Carper (
   • Jenica Wilkins (
   • Josh Booth (


1 This would apply to members who are residents, nonresidents or part-year residents.

2 States that had already enacted PTE taxes (or PTE tax elections) before the IRS Notice include Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island and Wisconsin.