California Governor Gavin Newsom on February 9, 2022, signed various adjustments to the state’s overall budget into law. The legislation—Senate Bill 113 (S.B. 113)—contains numerous tax law changes, including modifying the elective pass-through entity (PTE) tax, lifting both the net operating loss (NOL) suspension and business tax credits limit one year early, and conforming California to the federal treatment of certain pandemic-related grants.
Elective PTE Tax Modifications
In 2021, California enacted A.B. 150, which created a SALT deduction cap workaround allowing qualifying entities taxed as either S corporations or partnerships to elect to be taxed at the entity level. Similar to most other states that have enacted PTE tax election statutes, qualifying taxpayer-owners of an electing PTE are provided a tax credit equal to their share of tax paid by the PTE. However, as originally enacted, most taxpayers encountered a significant limitation on the California PTE tax election – a qualifying owner’s PTE tax credit was not creditable against the tentative minimum tax (TMT). For taxable years beginning on or after January 1, 2021, S.B. 113 corrects this legislative oversight and allows the PTE tax credit to reduce tax owed below the TMT. Nonetheless, for tax years beginning on or after January 1, 2022, S.B. 113 also modifies the ordering of California tax credits against “net tax” by placing usage of the tax credit for other state income taxes before usage of the PTE tax credit. The legislation also changes the definition of a qualifying entity to now allow PTEs with partners that are partnerships to make the election; however, the distributive share of such upper tier partnership-partner is not included in the calculation of the California PTE tax base and the upper tier partnership would not qualify to receive a share of the PTE tax credit. Additionally, S.B. 113 modifies the definition of a qualified member to include a limited liability company that is a disregarded entity for federal and California tax purposes and that is owned by an individual, estate or trust. Moreover, S.B. 113 clarifies existing law to include guaranteed payments in calculating qualifying PTE income subject to the elective PTE tax.
Early End to NOL Suspension for 2022
For tax years beginning on or after January 1, 2020, and before January 1, 2023, A.B. 85, enacted on June 29, 2020, suspended the deduction for NOLs for corporate taxpayers with at least $1 million of income subject to tax, and individual taxpayers with at least $1 million in net business income or modified adjusted gross income. S.B. 113 removes the NOL deduction suspension one year early, or for tax years beginning on and after January 1, 2022.
Early End to Business Tax Credit Suspension for 2022
Likewise, for tax years beginning on or after January 1, 2020, and before January 1, 2023, A.B. 85 also limited the usage of certain business tax credits to $5 million per year. S.B. 113 also removes this tax credit usage limit starting for tax years beginning on and after January 1, 2022.
California Conformity to Certain Federal Pandemic-Related Grants
S.B. 113 also conforms California to the federal income tax treatment of certain pandemic-related grant programs. For tax years beginning on or after January 1, 2020, grants made pursuant to the federal Restaurant Revitalization Fund are excluded from California gross income and business expenses paid with the funds are allowed as deductions for California personal and corporation income tax purposes. Additionally, for tax years beginning on or after January 1, 2019, grants made to eligible entities under the federal Shuttered Venue Operator Grant program are also excluded from California gross income and business expenses paid with the funds are allowed as deductions for California personal and corporation income tax purposes in conformity with federal law. However, similar to California’s treatment of Paycheck Protection Program loans, a venue operator is an “ineligible entity” if it is publicly traded or does not meet the 25% quarter-over-quarter gross receipts reduction of the Consolidated Appropriations Act, 2021.
Insights
This legislation is welcome in that it removes a significant limitation on the effectiveness of the California PTE tax election by making a PTE owner’s California PTE tax credit creditable against the TMT.
Further, a lower tier partnership in a tiered partnership structure may now be eligible to make the California PTE tax election, and partners or S corporation shareholders who hold their interests through a limited liability company that is a disregarded entity may now be qualified members.
S.B. 113 also creates the California Emergency Relief Fund, which appropriates $150,000,000 to fund small business grant applications waitlisted from previous rounds of the California Small Business Covid-19 Relief Grant Program.
Business credits for which the previously enacted limits have been removed for tax years beginning on and after January 1, 2022, include not only the R&D tax credit but also the California Competes credit, motion picture production credits and insurance gross premiums tax credits.
Written by Paul McGovern and Scott Smith. Copyright © 2022 BDO USA, LLP. All rights reserved. www.bdo.com