California became one of the 19 states and counting that has enacted its own pass-through entity (PTE) tax election statute as a workaround to the federal $10,000 limitation on the state tax deduction (the SALT deduction cap) when it enacted A.B. 150 on July 16, 2021. Unfortunately, that legislation currently includes a limitation on the use of the credit that significantly limits the benefit of making the election.
The Pass-Through Tax Credit and California’s Tentative Minimum Tax
Like the majority of states that have enacted PTE tax elections, California requires individual owners of PTEs making the election to include their distributive share of income from the PTE in their personal tax return, then provides the owners with a tax credit equal to their share of the state PTE tax paid by the electing entity. Unlike the other states that provide a pass-through tax credit mechanism, the California credit is non-refundable and any excess credit may be carried forward only five years.
Pursuant to Cal. Rev. & Tax. Code section 17062(a), California personal income tax equals the excess of the tentative minimum tax (TMT) for the tax year over the regular tax for the tax year. Among other items, including enactment of a new section 19900 to provide for a PTE tax election, A.B. 150 also enacted Cal. Rev. & Tax. Code section 17052.10(a), which is the PTE tax credit. Section 17052.10(a) provides that the PTE tax credit is used against the “net tax” defined in section 17039. In turn, Cal. Rev. & Tax. Code section 17039’s definition of “net tax” references only the regular California personal income tax code sections that are applicable to residents, part-year residents and nonresidents, but makes no reference to Section 17062, the TMT. As a result, it appears that without a legislative fix, the California PTE tax credit is not creditable against California TMT. Further, when the California Franchise Tax Board (FTB) updated its FAQs regarding the PTE tax election on October 1, 2021, the FTB summarily answered, as follows:
Q: Can the PTE credit reduce the amount of tax due below the tentative minimum tax?
A: No, the PTE tax credit does not reduce the amount of tax below the tentative minimum tax.
Accordingly, without a legislative fix, the California PTE tax election may not mitigate the SALT deduction cap as intended. While the TMT does not apply to income, adjustments and tax preference items attributable to trades or businesses owned by a taxpayer or owned by a PTE of which the taxpayer holds an ownership interest, when the aggregate gross receipts of the trades or businesses are less than $1 million, such taxpayers are likely subject to a California tax rate less than the 9.3% rate imposed on electing PTEs. Thus, for certain taxpayers, taking the PTE election results in a higher tax rate in addition to the credit’s other disadvantages (that the credit is not refundable and has only a five-year carryforward period). High-net worth individuals owning interests in PTEs are therefore more likely candidates to make, or to encourage their PTEs to make the election. However, the exclusion of the California TMT from the PTE tax credit appears to be a significant drawback for high earners considering the election.
In addition to the TMT limitation problem, there appears to be another issue that might dissuade a PTE from making the pass-through election in California. A.B. 150 does not include a provision to reduce the nonresident withholding requirements on electing PTEs. As a result, in addition to paying the elective PTE tax at a rate of 9.3%, the PTE is still required to withhold on nonresident individuals at a rate of 7%. To further add to the problem, it is unclear whether the PTE tax credit or the amount withheld should be applied against a nonresident’s California tax liability first. This is a problem, because as already noted, the credit is nonrefundable and can only be carried forward five years. A taxpayer may seek a waiver or reduction of withholding from the FTB based on the reasons identified on Forms 588 and 589 but making the California PTE tax election is not currently a listed reason for relief.
Thus, it appears that without some legislative fixes, there are few situations where it makes sense to make the California PTE tax election. As with any state in which a PTE is contemplating making one of these PTE tax elections, modeling the state tax effects of such elections is key to ascertain the overall impact of these SALT deduction cap workarounds to your total tax liability.
Written by Paul McGovern. Copyright © 2021 BDO USA, LLP. All rights reserved. www.bdo.com