AB 150: Passthrough Entity Elective Tax

As an update to our newsletter issued in late August, there have been some clarifying publications issued by the California Franchise Tax Board in connection with making the Passthrough Entity (PTE) tax election for qualifying entities.

Who can make the election?

The election allows any qualified entity to pay the California PTE tax (equal to 9.3% of its qualified net income) on behalf of the partner or shareholder.  As previously reported to you the primary benefit of this payment is to reduce the partner or shareholder’s Federal taxable income. Qualified entities that can make the election must be taxed / report as either a Partnership or S Corporation. It should be noted that an electing entity may not have any shareholders or partners that are partnerships, further it may not be part of a combined tax return filing or be a publicly traded partnership.  In the case of a shareholder or partner that is a single-member LLC, this does not disqualify the entity from offering the election to the other partners, however, the single-member LLC is not allowed to make the election to have tax paid on its behalf.

Qualified taxpayers eligible for the election are limited to individuals, trusts or an estate subject to California personal income tax. Each partner or shareholder is allowed to make the election for their respective share of the company’s income.  It should be noted that for S-Corporations, all income and deductions are split proportionately by shares held.  As such, under current law, if not all shareholders elect to participate in the PTE election, the deduction for California taxes paid will be allocated to all shareholders – including those who did not intend to elect to have a payment made on their behalf.  The AICPA has provided recommendations to the IRS to hopefully address this issue.

What is considered qualified net income?

Qualified net income is the sum of the pro rata share or distributive share of income of the entity’s owners. The California Franchise Tax Board has clarified that guaranteed payments made to partners are not included in qualified net income for purpose of the PTE tax.

Deadlines for making the election

For the 2021 tax year, the election for qualified entity to participate must be made with the timely filed tax return; however, the PTE payment must be made no later than March 15, 2022 regardless of an extension being filed.  Starting with the 2022 tax year, the qualified entity must make the PTE election for the tax year and the first required payment by the deadline date of June 15, 2022. If the payment is not made by June 15, then the entity will not be allowed to make the election for the entire tax year. As part of the estimated payment rules for PTE elections, the qualified entity electing to participate in the PTE program is required to pay the greater of 50% of the tax paid for the prior year (2021) or $1,000 by the June 15 deadline. The remaining amount is due by the entity’s original filing date (March 15 of the following year) but as mentioned previously, for the tax benefit of the payment to apply to the 2022 tax year, it would need to be paid by December 31, 2022.

Limitations to the Use of the PTE Payment

Due to unclear language within the law, the ability to use the PTE Tax payment to offset California income taxes has come into focus in recent months.  The PTE Tax payment is effectively treated as a tax credit rather than an estimated tax payment and is not currently allowed to offset the California tentative minimum tax.  This means, that under current law, that the PTE Tax payment may not be used to fully reduce California taxes in the year that it is paid, if limited by California AMT.  Any unused PTE Tax payment due to current year AMT limitations may be carried forward and used for up to five years after the year in which it was paid.  As such, coordination will be necessary to ensure the payment is utilized to the greatest extent possible before it expires.  AB 87/SB 113 has recently been introduced which would address this issue as well as other limitations; however until its passing, it’s important to understand the potential limitations of making the PTE election if one is not able to utilize the full tax payment to offset California taxes.

Please reach out to your DKC representative to discuss any questions and potential benefits of how this election may apply to your individual tax situation.

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