The California Pass-Through Entity Tax Provides Necessary Relief and Reflection
August 02, 2021
By Andrew Cohen
With the goal of providing relief to small businesses “facing unprecedented economic hurdles due to COVID-19,” California in Assembly Bill 150 joined the numerous states that have enacted a pass-through entity tax. The California pass-through entity tax (“CA PTET”), also known as the Small Business Relief Act (“CA PTET”), is effective for taxable years beginning on or after January 1, 2021 and will sunset on December 31, 2025 (or January 1 of the tax year after any repeal of Internal Revenue Code Section 164(b)(6)). The CA PTET is in addition to, and not in place of, any other tax or fee that may apply to the entity. As the CA PTET is an elective tax, it is similar to many other states with a pass-through entity tax; however it differs on who is required to consent to make the election, what portion of income is subject to the tax, who can claim the credit and the nature of the credit allowed (refundable v. nonrefundable). The CA PTET, with its high tax rate (9.3%), provides qualified taxpayers with an opportunity to obtain some tax relief regarding the federal SALT Cap.
A qualified taxpayer is either an individual, fiduciary, trust or estate as defined by California Revenue and Tax Code Section 17004 (excluding partnerships); or a corporation, as defined by California Revenue and Tax Code 23038 (including associations, limited liability companies classified as associations, business trusts, and other business entities electing to be taxed as corporations) that are partners, shareholders, or members of an electing flow-through entity. A qualified taxpayer must consent to have their pro rata share or distributive share of income calculated in accordance with California’s personal income tax (Part 10) or corporate income tax (Part 11) included in the entity’s net income subject to the 9.3% elective tax. All flow-through entities that are qualified entities can elect to pay the CA PTET. Flow-through entities include S corporations, limited liability companies, limited liability partnerships or limited partnerships (hereinafter “Qualified Entities”). However, disregarded entities are precluded from electing to pay the tax; and it is unclear, based on the language of the statute, if a general partnership can elect to pay the CA PTET. A qualified entity is a pass-through entity that does not have a partnership as an owner, is not part of a combined group, and is not a publicly traded partnership.
The 9.3% elective tax is paid on the sum of the pro rata shares or distributive shares of net income of any of its partners, shareholders or members that consent to the election. Thus, the annual election to pay the CA PTET can be made without the consent of all of the partners, members or shareholders. The election can only be made on an original, timely filed return without regard to extensions. Once an election is made, it is irrevocable and binding on all of the entity’s partner’s members or shareholders.
For the tax year beginning on or after January 1, 2021 and before January 1, 2022, the CA PTET return and payment is due on March 15, 2022. The provisions of Assembly Bill 150 do not require the payment of estimates for the 2021 tax year. However, for tax years beginning on or after January 1, 2022 (and before January 1, 2026), the pass-through entity will be required to make minimum estimated tax payment(s) on or before June 15. The minimum required estimated tax payment is the greater of 50% of the prior year elective tax paid or $1,000. This $1,000 payment would be the required minimum estimated tax payment if, in a prior year, the qualified entity does not elect into the CA PTET. The remaining 50% of the elective tax is due on or before March 15. It is important to note that if the required minimum June 15 estimated tax payment(s) is/are not made by the qualifying pass-through entity, the entity is precluded from making the CA PTET election for that taxable year. As a result of this unique provision in the legislation, the qualified entity must decide by June 15 of the taxable year of the election if it is going to make the election into the CA PTET, and then make the required estimated tax payments before actually electing to pay the tax.
One other unique provision of the CA PTET is that each consenting qualified taxpayer is entitled to a nonrefundable credit equal to his or her pro rata or distributive share of taxes paid by the entity on his/her behalf. Any unused credit of the partner, member or shareholder can be carried forward for up to five years, or until exhausted. The nonrefundable credit and the five-year carryover rule are two key differences between the CA PTET and all the other states that have a pass-through entity tax that provide for a refundable credit.
There are several important issues regarding the CA PTET that require the attention of qualified entities. First, qualifying entities must be cognizant of making the requisite minimum estimated tax payment(s) by June 15 for tax years beginning on or after January 1, 2022. If the entity fails to make the required minimum estimated tax payment(s) by that date, it is precluded from electing into the CA PTET for that taxable year. There is currently no relief for late payments of the June 15 required estimated tax payment amounts. Thus, the qualifying entity must decide to elect into the CA PTET by June 15 of the year prior to when the election is due.
Additionally, consideration should be given as to whether the qualifying entity should make additional estimated tax payments after June 15 and before March 15. California Revenue and Tax Code Section 19904(a)(2)(B) requires the qualified entity to pay on or before the due date of the return the total elective tax, minus the required minimum estimated tax payment due on June 15. This language of the statute leaves open the possibility to make additional estimated tax payments before the March 15 due date. Qualified entities should consider making these voluntary payments to increase the amount of the federal deduction for taxes paid for that year. This is particularly true for qualifying entities that use the cash method of accounting, and thus deducts their expenses in the year they are paid.
Another consideration is regarding S corporations and the election to pay the CA PTET. S corporations could potentially violate their S election if all of their shareholders do not consent to making the election. S corporations can only have one class of stock. Generally, an S corporation is considered to have one class of stock when all outstanding corporate shares of stock have identical rights of distribution and liquidation proceeds. If only some of the S corporation shareholders consent to making the election, the S corporation may breach the one class of stock rule, as not all the shareholders would have an identical right to the CA PTET credits and may receive disproportionate distributions.
The CA PTET is a welcome addition to the number of states that have already passed a pass-through entity tax. With its January 1, 2021 effective date, planning as to whether or not to elect into the CA PTET can begin now for the 2021 tax year. There are currently numerous open issues and questions regarding the CA PTET, but hopefully additional guidance will be provided shortly. Despite the current lack of guidance as to how to make estimates and file the CA PTET return: Given the high tax rate of 9.3%, provided effective planning is undertaken, there may be clear benefits for deciding to elect into the CA PTET.