Understanding California’s Pass-Through Entity Elective Tax

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By: Heena Patel

Taxpayers who itemize on their federal tax returns can deduct certain state and local taxes (SALT). In 2017, The Tax Cuts and Jobs Act (TCJA) capped SALT deductions at $10,000. To counter this cap, the California Assembly recently introduced a pass-through entity (PTE) elective tax. Owners of qualifying entities that elect to pay the PTE tax can claim a tax credit on their California individual income tax returns.

what is the pte tax election?

The pass-through entity (PTE) tax allows certain California pass-through entities to pay state income tax at the PTE level. In return, qualified owners can get a nonrefundable tax credit for their share of the entity level state tax, which reduces their personal income tax for California. Any PTE tax credit that exceeds a taxpayer’s California personal income tax for the current year can be carried forward for up to five years.

The PTE tax is available for the tax years January 1, 2021 through December 31, 2025 for qualifying companies.

who can make the pte tax election?

Partnerships and S corporations qualify if their owners are exclusively individuals, corporations, fiduciaries, estates, and trusts. Qualified PTEs do not include:

  • Publicly traded partnerships.
  • Entities permitted or required to be in a combined reporting group.

To take advantage of this election, a qualified PTE must make an irrevocable annual election on an original timely filed return. The election is binding on all partners, members, and shareholders.

what counts as income for the pte tax election?

The PTE tax and credit is equal to 9.3% of each taxpayer’s qualified net income. Qualified net income is each consenting qualified taxpayer’s total pro rata or distributive income and guaranteed payments that are subject to California income tax.

For California resident owners, the PTE tax base includes the organization’s income before it has been apportioned. Apportionment is the process of determining what percentage of a company’s gross profits are subject to California taxes.

For nonresident owners, the organization’s income earned in California is included in the PTE tax base.

The PTE tax base does not include the income of corporations, disregarded entities, and other non-qualified taxpayers.

example of a pte election

ABC Tech LLC is a partnership with two equal partners. The company has a qualified net income of $200,000. If both partners qualify and make the PTE election, the partnership can pay a PTE elective tax of to the California Franchise Tax Board. Each partner will report $90,700 of net income (($200,000 – $18,600) X 50%) on their federal K-1.

When the partners file their personal returns, their California returns will report $100,000 of net income from ABC Tech LLC (90,700 federal income + 9,300 share of PTE tax paid to CA) and a tax credit of $9,300 against their individual California income tax.

tax payment due dates

For tax year 2021, the PTE tax payment is due on the due date of original tax return, not including extensions.

For tax years 2022-2025, taxpayers must submit the PTE tax in two payments. The first payment is due on June 15th of the taxable year, or on the 15th day of the sixth month for fiscal year taxpayers. The amount due is the greater of:

  • 50% of elective tax paid in a prior year, or
  • $1,000.

things to keep in mind related to the election 

Although this new elective tax may be beneficial to certain taxpayers, there are complicated situations that can arise.

  • Non-resident shareholders: If a pass-through entity has non-resident shareholders, members, or partners, then the credit is applicable only for the California-sourced income.
  • Distributions for S corporations: S corporations must be mindful to 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 action item: As of February 9, 2022, California law SB 113 allows the PTE tax credit to reduce the tentative minimum tax. Prior to SB 113, many qualified taxpayers with high K-1 incomes did not take the PTE elective tax credit because it did not reduce their California tax liability amount below the tentative minimum tax. Because PTE tax payments are due by March 15, 2022, taxpayers with high K-1 incomes should meet soon with their tax professionals to decide whether to make the election for the 2021 tax year.

conclusion

Want to determine whether the PTE elective tax would benefit your company? Interested in other forms of tax planning? Consult with an experienced Chugh CPAs, LLP tax professional for personalized advice.