To Our Valued Clients and Friends,
The last few years have included a plethora of changes in the tax landscape and now state tax law changes have begun to catch up with some of the federal tax implications. In 2018, the Tax Cuts and Jobs Act limited federal deductibility of state taxes (including property taxes and state income taxes) to $10,000.00 per return. For California residents this had a significant impact on itemized deductions at the federal level.
IS THERE ANYTHING THAT CAN MITIGATE THIS LIMITATION
California recently passed AB 150, which included a provision to establish an elective passthrough entity (PTE) tax. This passthrough entity tax is intended to provide California taxpayers a method to structure their state income tax compliance in a way which provides some relief from the current federal limits on individual state and local tax deductions.
For the 2021 through 2025 taxable years, a qualified S Corporation, Partnership, or LLC taxed as Partnership or S Corporation that is doing business in California, and is required to file a California return, may make an election to pay a passthrough entity tax equal to 9.3% of its qualified net income.
WHY WOULD MY BUSINESS MAKE THIS ELECTION?
Paying tax at the entity level will decrease the federal net income included on the owners’ Schedule K-1 by the amount of the tax paid. In essence, this allows the Schedule K-1 recipient to reduce federal adjusted gross income rather than having a state tax deduction on Schedule A, which would be subject to the $10,000 state and local tax (SALT) deduction limit. For federal purposes, the owner will reduce net income by the amount of the tax. For California the tax will be added back into net income, but the owners will receive a California tax credit equal to the state tax paid by the passthrough entity on behalf of the owner.
MAY I SEE AN EXAMPLE OF HOW THIS WORKS?
Wanna Save LLC, which is taxed as a partnership, has qualified net income of $100,000. Two partners each have a 50% interest. If both partners qualify, and the election is made, the partnership makes a payment of $9,300 to the Franchise Tax Board. The partnership then reports $45,350 (($100,000 – $9,300) × 50%) of net income on each of the federal Schedule K-1s. The California returns filed by the partners will report $50,000 of net income from Wanna Save, LLC ($45,350 of federal net income plus the $4,650 of elective passthrough entity tax paid to California), and a credit of $4,650 against their individual California income tax.
DOES MY BUSINESS QUALIFY?
Entities are qualified to make this election only if they meet both of the following requirements:
· The entity is taxed as a Partnership or S Corporation; and
· The entity’s partners do not include other partnerships.
WHAT DO I NEED TO DO?
The election is made annually, is irrevocable, and may only be made on an original, timely filed return. We will need to work together to see if this makes sense for each taxpayer and whether the election is reasonable.
If we prepare your personal tax returns, but not your passthrough entity returns, we will want to discuss what is happening with your other passthrough entities. For your personal tax planning, we will need to know if other entities are making this election to ensure we are not recommending incorrect state tax payments.
WHAT IS THE TIMING FOR PAYMENT OF THIS NEW TAX?
For this initial year (tax year 2021), the tax is due on the filing date of the original return, without regard to extensions. This date is March 15, 2022 for calendar year taxpayers.
However, the due date is different for the tax years of 2022 through 2025. In those years, the entity must make 2 payments, with the first payment being due by June 15th of the taxable year. For the 2022 tax year, this first payment would be due June 15, 2022. If the entity fails to pay the amount due by June 15th, the entity will be prohibited from making an election to pay the passthrough entity tax for that year.
The IRS has given its stamp of approval for this type of passthrough entity tax. However, the timing for the deduction of the state tax payment will be determined by the date of deposit with the state. This would mean that a tax payment made in 2022 that is applicable for the 2021 year would only be deductible on the 2022 income tax return for federal purposes. For the 2021 payment to be deducted on the 2021 income tax return, it would need to be deposited by December 31, 2021.
If you have any questions or concerns, please do not hesitate to contact us.
Wishing You a Glorious Harvest Season,
Maeda Palius, Jason Janzen, Annika Jensen and the POJ Team