July 22, 2021
Governor signs bill establishing elective pass-through entity tax in California
On July 16, 2021, Governor Gavin Newson signed 2021 California Assembly Bill 150 (2021 Cal. Stat. Ch. 82) (AB 150), establishing a new elective pass-through entity-level tax (PTE tax). The legislation enables California taxpayers who own PTEs to receive a credit for their share of the PTE-level state and local taxes deducted by partnerships and S corporations, allowing them to exceed the $10,000 state and local tax deduction limitation imposed by IRC Section 164(b)(6) (the SALT deduction limitation), consistent with IRS Notice 2020-75 (see Tax Alert 2021-0092). The legislatively-stated goal of the PTE tax is to provide tax relief to small businesses facing unprecedented economic hurdles due to COVID-19.
AB 150 incorporates much of the language of a bill introduced earlier this year in the California legislature (2021 Cal. SB 104 (SB 104); see Tax Alert 2021-1007) but makes some subtle, but significant, changes to SB 104's PTE tax scheme. As enacted, for tax years beginning on or after January 1, 2021 and before January 1, 2026, AB 150 allows a qualifying PTE doing business in California to annually elect to pay a 9.3% tax according to, or measured by, the PTE's net income for the tax year for which the election is made.1 As a result of the elective tax paid, a "qualified taxpayer" will be allowed a credit equal to the "qualified amount"2against the "net tax."3 Under SB 104, a qualified taxpayer would have only been allowed a credit equal to 94.9% of the "qualified amount."
AB 150 defines a "qualified taxpayer" to include any individual, fiduciary, estate or trust subject to personal income tax under Part 10 of the CRTC (California's personal income tax).4 To be entitled to the credit, qualified taxpayers must be a consenting PTE owner5 that agrees to have its pro rata share or distributive share of income (as determined by Part 10 of the CRTC) included in the "qualified net income" (i.e., the sum of all such shares) of the "electing qualified entity" (i.e., an electing partnership, S corporation or limited liability company (LLC) electing to be treated as a partnership or S corporation).6
Unlike SB 104, AB 150 expressly excludes disregarded entities (DREs) from the definition of a "qualified taxpayer" but does not clarify whether DREs will be ignored at the qualified taxpayer or qualified entity level, or will cause disqualification of the entity electing to apply the PTE tax. In addition, AB 150 defines more specifically than SB 104 the terms "qualified taxpayer"7 and "qualified net income," and allows for non-consenting owners to continue to own interests in PTEs without disqualifying the PTE from being able to otherwise elect into the PTE tax regime.8 In contrast, SB 104 appeared to require that all owners had to consent to the PTE election for the PTE election to apply. Regardless, AB 150 binds all owners by the PTE's election9 but excepts from the PTE tax base the distributive or pro rata share of the PTE's income allocated to nonconsenting owners.10
An "electing qualified entity" is a PTE that is (1) doing business in California, (2) taxed as a partnership or S corporation, (3) that has PTE members that are exclusively corporations or qualified taxpayers and (4) that has elected to pay the PTE tax.11 Partnership entities that are not limited or limited liability partnerships and that are not "taxed" under CRTC Sections 18633, 18633.5 or Section 18601(a) are specifically excluded from the definition of "qualified entity."12 Nonetheless, the language of AB 150 broadens the list of qualified entities to include PTEs with corporate owners (unlike SB 104).
A qualified entity can elect to pay the PTE tax annually on its original, timely filed return.13 Once made, the election is irrevocable.14 For tax years beginning on or after January 1, 2021 and before January 1, 2022, the elective PTE tax is due and payable on or before the filing due date of the original return without regard to extension.15 For each tax year beginning on or after January 1, 2022 and before January 1, 2026, the PTE must pay by June 15 of the tax year of the election the greater of 50% of the elective tax paid in the prior year or $1,000. The PTE must pay the remaining amount on or before the filing due date of the original return without regard to extension.16 The elective PTE tax is in addition to any other required personal or corporate income tax.17 A taxpayer can carry forward the amount of credit exceeding the "net tax" due to the following tax year, and the succeeding four years, until exhausted.18 AB 150 is more lenient in this regard in that under SB 104 that carryforward period would have been only three years.
Section 15 of AB 150 specifically states that the PTE tax is effective only until December 1, 2026, unless repealed sooner, and any earlier repeal of the SALT deduction limitation by Congress would cause California's PTE tax to be repealed as of December 1 of that same tax year.19
In November 2020, the IRS indicated its intention in Notice 2020-75 to propose regulations clarifying that a partnership or an S corporation computing non-separately stated taxable income or loss for federal income tax purposes could deduct state and local income taxes imposed on its net income for the tax year at issue without regard to the SALT deduction limitation (see Tax Alert 2020-2690). Those regulations have yet to be proposed. In light of the IRS's announcement, some states have enacted an entity-level tax to provide the federal tax benefit to PTE owners in their states.20 California now follows these states. Other states continue to propose such legislation.21
It is unclear whether the current list of qualifying PTEs is intended to exclude general partnerships, as these entities are not listed in the bill analysis for AB 150 and are not "taxed" as partnerships in California. Further, taxpayers or entities considering the PTE election should consider whether AB 150's exclusion of DREs from the definition of "qualified taxpayer" results in disqualification of affected PTEs in that structure from making a valid PTE election. Unlike similar PTE tax laws enacted in other states, AB 150 does not address nor provide an explicit mechanism to credit California resident taxpayers for their distributive share of similar PTE taxes paid to other states. The modification of the PTE tax to a credit for PTE members, however, may enable California resident and nonresident taxpayers to use California's existing "other state tax credit" provisions set forth in CRTC Sections 18001 through 18006 to do so. The California Franchise Tax Board is expressly authorized to provide regulations to implement the PTE tax law.22 It is unclear when such regulations and guidance may be made available.
1 See AB 150, Section 15 (Small Business Relief Act), which adds Part 10.4 to the California Revenue & Taxation Code (CRTC) and will consist of new CRTC Sections 19900 — 19906. Section 7 of AB 150 adds CRTC Section 17052.10, which provides "qualified taxpayers" (i.e., taxpayers subject to the California personal income tax law but specifically excluding partnerships) with the credit for their respective share of the PTE tax paid by the PTE.
2 See AB 150, Section 7, adding CRTC Section 17052(b)(2), which defines the "qualified amount" as "an amount equal to 9.3[%] of the qualified taxpayer's pro rata share or distributive share, as applicable, of qualified net income subject to the [PTE tax] election made by an electing qualified entity under Part 10.4 [i.e., the PTE tax law] … "
3 "Net tax" is defined by CRTC Section 17039 to refer to the personal income tax imposed on residents, nonresidents and part-year residents, less certain exemption credits and adjustments for interest on installment obligations.
4 See the definition of "taxpayer" in CRTC Section 17004. New CRTC Section 17052.10(b)(3)(B) added by AB 150, Section 7, specifically excludes from the definition of "qualified taxpayer" partnerships and any business entity that is disregarded for federal tax purposes.
5 A PTE owner may be a partner, shareholder, or member of the PTE. PTE owners eligible for the credit include residents, nonresidents or part-year residents of California.
6 CRTC Section 19900(a)(2) as added by AB 150, Section 15. CRTC Section 19902(b) specifically excludes from the definition of "electing qualified entity" publicly traded partnerships and any entity permitted or required to be included in a combined reporting group. CRTC Sections 19900(a)(1), 19902(b) and 17052.10(b)(1) set forth the requirements for a PTE to qualify for and make a PTE tax election.
7 See CRTC Section 17052.10(b)(3)(B).
8 CRTC Section 19900(c)(1) ["The qualified entity may include in its qualified net income the pro rata share or distributive share of the income of any of its [owners] upon their consent. A[n owner] that does not consent does not prevent the qualified entity from making an election to pay the elective tax."]
9 See CRTC Section 19900(c)(2).
10 See CRTC Sections 17052.10(b)(3) (defining "qualified taxpayer") and 17052.10(b)(2) (defining "qualified amount").
11 CRTC Sections 19900(a)(1), 19902(b) and 17052.10(b)(1).
12 CRTC Section 19900(a)(1).
13 CRTC Sections 19900(a)(1) and (d).
14 CRTC Section 19900(d).
15 CRTC Section 19904(a)(1).
16 CRTC Section 19904(a)(2).
17 CRTC Section 19900(b)(1).
18 CRTC Section 17052.10(c).
19 CRTC Section 19906(b).
20 Connecticut, Louisiana, Maryland, New Jersey, Oklahoma, Rhode Island and Wisconsin had already enacted mandatory or elective PTE taxes similar to that now enacted by California under AB 150 prior to the issuance of IRS Notice 2020-75.
21 After IRS Notice 2020-75 was issued, Alabama, Arizona, Arkansas, Colorado, Georgia, Idaho, Minnesota, New York and South Carolina enacted similar PTE-level taxes. In addition, similar elective PTE bills are pending before the governors of Illinois and Oregon. Michigan's bill was vetoed by the governor and the governor of Massachusetts offered amendments to the provision approved by the legislature. Bills that would implement a similar elective PTE tax are currently being considered in North Carolina and Pennsylvania.
22 CRTC 19904(d).