[The original November 3, 2021, post was updated on February 17, 2022, to add additional information from recently passed California’s Senate Bill 113 (SB 113)]
The 2017 Tax Cuts and Jobs Act reduced taxes for most taxpayers. However, this law limited the itemized deduction for state and local taxes paid by individuals at the federal level to a maximum of $10,000. States have been looking for work-arounds to this limitation since the passage of the Tax Cuts and Jobs Act. In the fall of 2021, California passed legislation that allows a work-around of this limitation for owners of pass-through entities that has been approved by the IRS.
For the 2021 through 2025 taxable years, a qualified S corporation, partnership, or LLC taxed as a 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. A single member (SMLLC) cannot make this election. To be eligible, the LLC must add a member or elect to be treated as an S corporation. However, an SMLLC owned by a husband and wife can elect to be taxed as a partnership and can qualify to pay the passthrough entity tax.
Why make the election?
Paying this Pass-through Entity Elective Tax (PEET) at the entity level will decrease the federal net income included on the owners’ K-1 by the amount of the state tax paid. In essence, this allows the K-1 recipient to reduce federal Adjusted Gross Income (AGI) 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 California, the tax will be added back into net income because state taxes paid do not give rise to a deduction on the California return. The participating owners will receive a California tax credit equal to 100% of the state tax paid by the passthrough entity on behalf of the owner.
Qualified entity
Entities are qualified to make the election only if they meet both of the following requirements for the taxable year:
The entity is taxed as a partnership or S corporation; and
The entity is not a publicly traded partnership, or required or permitted to be included in a combined report.
Prior to SB 113, if an entity had a partnership owner, it could not be considered a qualified entity.
Qualified net income
Qualified net income is the sum of the consenting individual, trust, or estate owners’ pro rata share, or distributive share, of the entity’s income subject to California tax, including interest, dividends, and capital gains. This means for California residents it includes all income from the passthrough entity, but for nonresidents it only includes the entity’s apportioned California-source income.
Only “qualified taxpayers” can consent to have their share of income paid by the passthrough entity. Corporation and partnership owners of partnerships are not “qualified taxpayers” and cannot elect to have the passthrough entity pay tax on their distributive share of net income. SMLLCs owned by individuals can be considered qualified taxpayers.
The entity may still elect to pay the tax even if some of its owners do not consent. However, the amount of qualified net income does not include the nonconsenting owners’ share of the entity’s income.
Making the election
The election is made annually, is irrevocable, and can only be made on an original, timely filed return, including extensions.
Entities will have to reach out to their partners/shareholders/members to determine whether any of them consent to have the entity pay the tax on their behalf. The tax will only be paid on behalf of consenting owners. S corporations that elect to pay the tax on behalf of their consenting shareholders must make “compensating” distributions to their nonqualified or nonconsenting shareholders to avoid making disproportionate distributions and jeopardizing their S corporation status.
For years 2022 through 2025, the decision to participate in the PEET credit must effectively be made by June 15 of the elected year, because if a portion of the tax is not paid by that date, the election is not available.
Paying the tax
For the 2021 taxable year, the tax is due on the due date of the original return, without regard to extensions (March 15, 2022, for calendar-year taxpayers). For the 2022 through 2025 taxable years, the entity must make two payments. The first payment is due by June 15 of the taxable year, or the 15th day of the six month of the taxable year for fiscal year taxpayers. The amount due is the greater of:
50% of the elective tax paid for the prior year; or
$1,000.
The remaining amount that brings the total to 9.3% of qualified net income must be paid by the entity’s original filing date deadline (March 15 for calendar-year taxpayers). If the entity fails to pay the remaining amount due by the entity’s original filing date deadline, any underpayment will incur late payment penalties and interest. Overpayments on extended entity returns can be refunded.
Year of deduction
The IRS gave its stamp of approval to these type of passthrough entity taxes in IRS Notice 2020-75 and stated that they intend to issue proposed implementing regulations clarifying the treatment of taxes on both the entity’s and owners’ returns.
The notice appears to state that the passthrough entity would deduct the tax in the year the tax is paid and that the tax payment would reduce the passthrough entity’s distributable net income reported on the owner’s K-1 for the year the tax is paid.
This would mean that a tax payment made in 2022 for the 2021 tax year would qualify for a 2021 credit on the owners’ California returns, but will be deducted on the partnership’s 2022 tax return and reduce net income on the owners’ 2022 federal K-1. We are waiting to see if the forthcoming regulation confirms this interpretation.
Credit use and carryover
The credit was previously only allowed to the extent that regular California tax exceeded Alternative Minimum California tax. SB 113 removed this limitation. California tax credits unused by the owner of the electing passthrough entity may be carried forward for up to five years and are then lost.
Interplay with consenting owners’ estimated taxes
According to the FTB, qualified taxpayers reduce the amount of their overall tax due by the amount of passthrough entity tax credit that they claim for purposes of determining any underpayment of estimated tax penalties. However, prepayments of the credit amount are not considered estimated tax payments.
When projecting third and fourth quarter estimated tax payments, taxpayers should not consider the credit amount as an estimated tax payment. Instead, reduce projected tax liability by the credit amount, and use that reduced amount to calculate third and fourth quarter estimate payments.
This issue is especially important for high-income taxpayers who cannot rely on the estimated tax prior-year safe harbor.
Forms
Form 3893 is used to report the early or first portion of the tax paid at the pass-through entity level.
Form 3804 is used to report the remaining tax payment by the entity’s original filing date deadline.
Form 3804-CR is used on the owner’s personal tax return to report the credit.
This commentary is based on guidance provided by Spidell Publishing Inc. (caltax.com).
If you would like more information on this topic or another tax topic of interest to you, please contact our office.
—McAvoy + Co, CPA