California Passes SALT Deduction Cap Workaround but Limits the Benefit to Certain Pass Through Entities

California Governor Gavin Newsom signed into law budget legislation that includes a workaround of the $10,000 federal cap on state and local tax (SALT) deductions implemented under the Tax Cuts and Jobs Act (TCJA). The workaround, however, limits the number of qualifying entities by excluding partnerships that are  owned by other partnerships. This limitation may surprise many individual taxpayers that may be unable to benefit from the new law due to the pass through entity ownership limitations.

The Small Business Relief Act, which is included in Assembly Bill 150, will allow 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 workaround will be in effect for tax years 2021 through 2025, when the federal SALT deduction cap is set to expire. If the SALT deduction limit is repealed before December 1, 2026, the law would become inoperative for the years for which the limit is repealed.

Election to Pay Tax at Entity Level

Under the new law, a “qualified entity” may make a yearly irrevocable election to pay the 9.3 percent state income tax on its “qualified net income,” which is the sum of the pro rata share or distributive share of the income of the partners, shareholders, or members that is subject to California’s personal income tax for the taxable year. Entity owners must consent to having their income subject to the tax. An owner that does not consent does not prevent the entity from making the election, but the nonconsenting owner’s income is excluded from the tax. The consenting entity owners would then be eligible for a non-refundable tax credit in an amount equal to the elective tax paid on their behalf. Any amount of credit that exceeds the “net tax” can be carried forward for five years.

A “qualified entity” is an S corporation or an entity that is “taxed as a partnership” in California, which includes limited liability companies (LLC), limited liability partnerships (LLP), and limited partnerships (LP), and is owned solely by corporations, individuals, fiduciaries, estates, or trusts. (General partnerships are not “taxed as a partnership” in California and are not qualified entities.) The entity cannot be a publicly traded partnership or an entity permitted or required to be in a combined reporting group.

An entity owner, known as a “qualified taxpayer,” is a taxpayer as defined under Section 17004 of the California Revenue and Taxation Code, excluding partnerships, that is a consenting partner, shareholder, or member of a qualified entity. The exclusion of partnerships as a “qualified taxpayer” greatly limits the applicability of the workaround. For example, a limited partnership that has a partnership as its general partner would be ineligible to make the election. Additionally, a “qualified taxpayer” cannot be a disregarded entity for federal tax purposes, or its partners or members.

Election and Payment of the Tax

The entity must make the election on an original, timely filed return for the taxable year of the election in the form and manner as prescribed by the California Franchise Tax Board.

For taxable years beginning on or after January 1, 2021, and before January 1, 2022, the entity must pay the tax annually on or before the due date of the original return without extension. This would be March 15, 2022 for calendar-year entities.

For taxable years beginning on or after January 1, 2022 and before January 1, 2026, the entity must pay a minimum amount equal to the greater of 50 percent of the elective tax paid the prior taxable year or $1,000. The entity must make the payment on or before June 15 of the election year to be eligible to make the election. The qualified entity is then required to file and pay the remaining balance of the elective tax on or before the original due date of the return without extension.

Status of Other States

California is the latest state to pass a SALT cap workaround since the TCJA imposed the deduction cap. In 2019, Wisconsin and Connecticut were the first states to adopt a SALT workaround through a pass-through entity-level income tax for tax years after January 1, 2018. In 2019, Louisiana, Rhode Island, and Oklahoma adopted entity-level tax laws for tax years after January 1, 2019. In 2020, Maryland adopted an entity-level tax for years after December 31 2019 and New Jersey adopted an entity-level tax for tax years after January 1, 2020.

In November 2020, the IRS issued Notice 2020-75, which approved the use of an entity-level tax on owners of pass-through entities as a mechanism to avoid the SALT deduction cap, prompting more states to implement the tax change. States that have since adopted pass-through entity-level income taxes for tax years after January 1, 2021 include Alabama, Idaho, Massachusetts, and South Carolina. Arizona also implemented a pass-through entity-level income tax for tax years after December 31 2021; laws in Colorado and Georgia are effective for tax years after January 1, 2022; New York’s pass-through entity-level tax is retroactive to January 1, 2020; Minnesota’s is retroactive to December 31, 2020; and Oregon’s is effective for tax years 2022 and 2023.

The legislature in Illinois has passed entity-level taxation bills that is awaiting the governor’s approval. Michigan’s governor vetoed that state’s entity-level taxation bill, citing the cost of implementing the bill. An entity-level taxation bill has also been introduced in North Carolina.

Given the possible differences between state laws, taxpayers should review their state’s tax statutes before making an election to understand the specific impact on each pass-through entity owner. The election may affect each owner differently depending on specific circumstances, including whether they are a resident or a non-resident and whether they have other ownership interests.

For more information, contact us. We’re here to help.

© 2021