California Expands SALT Workaround and Repeals NOL and Business Credit Limits

Recently passed budget legislation in California will bring significant tax reductions to business and individual taxpayers. SB 113, which Governor Gavin Newsom signed into law on February 9, 2022, expands the state’s workaround of the federal deduction limit for state and local taxes (SALT) and repeals the net operating loss (NOL) suspension and business credit limits that were implemented in 2020. The legislation follows Newsom’s record $286.4 billion budget proposal for 2022-2023, which outlined similar tax changes. The early repeal of the NOL suspension and business credit limits comes amid strong tax revenues and a $45.7 billion budget surplus.

Expansion of SALT Cap Workaround

SB 113 expands the SALT cap workaround by allowing the credit for taxes paid by the entity to offset the California tentative minimum tax of 7 percent of taxable income for tax years beginning on or after January 1, 2021. For tax years beginning on or after January 1, 2022, the law requires the credit to be applied against the net tax after credits for taxes paid to other states.

The prior version of the law, known as the Small Business Relief Act, allowed S corporations and certain partnerships doing business in California to elect to pay a 9.3 percent state income tax with the entity owners eligible to receive a tax credit for their share of the tax. The law, however, limited the pass-through entity tax credit to an individual tax liability over the tentative minimum tax. By allowing the credit to offset the California tentative minimum tax, SB 113 enables taxpayers to claim the full amount of the pass-through entity tax credit. (See California Passes SALT Deduction Cap Workaround but Limits the Benefit to Certain Pass Through Entities)

SB 113 makes several other changes to the SALT cap workaround. The law allows a partnership to be an eligible partner, shareholder, or member for purposes of a qualified entity. Limited liability companies owned by individuals through a disregarded entity are now eligible for the workaround. The law also includes specified guaranteed payments made to partners as qualified net income.

Repeal of NOL and Credit Limits

SB 113 repeals the NOL suspension and the $5 million annual cap on business tax credit claims for tax years beginning after January 1, 2022. This reinstates the NOL deduction and the business tax credits a year early, as the California legislature originally imposed the limits for 2020, 2021, and 2022 to raise revenue in response to the economic downturn caused by the COVID-19 pandemic. The NOL suspension for 2020 and 2021 still applies to corporate and individual taxpayers with net business income or “modified adjusted gross income” of more than $1 million and allows an extended carryover period for deductions denied under the provision. The limit on business incentive tax credits for 2020 and 2021 remains at $5 million for a combined group. (See California Corporate Tax Changes Look to Raise Revenue and Aid Small Businesses)

Tax Reductions for Restaurants and Entertainment Venues

SB 113 includes significant tax breaks for restaurants and entrainment venues. The law excludes federal restaurant revitalization grants from gross income for tax years beginning on or after January 1, 2020 and excludes federal shuttered venue operator grants from gross income for tax years beginning on or after January 1, 2019. It also allows expenses paid with these grants to be deducted. These changes conform California law to federal law.

The law also excludes from income relief payments that customers receive from community water systems, wastewater treatment providers, or utilities for tax years beginning on or after January 1, 2021, and before January 1, 2026.

Impact on Taxpayers

The changes in SB 113 benefit taxpayers by allowing the pass-through entity tax to provide a larger benefit to individual California taxpayers and by reinstating critical tax deductions and credits. Newsom requested that changes to the pass-through entity tax be enacted before the March 15, 2022 tax filing and payment deadline for pass-through entities that make the election for 2021. SB 113 passed the Senate and the Assembly unanimously.

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