The California Pass-Through Entity Tax Provides Necessary Relief and Reflection
November 17, 2021
By Andrew Cohen
Updated to reflect recent developments on November 10, 2021
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, 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 that of 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). California recently issued guidance on the CA PTET in the form of FAQ Bulletins. 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); that is a partner, shareholder or member of a qualified entity that consents 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. 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.
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”). General partnerships also meet the qualifications for the CA PTET election. Stand-alone disregarded entities and corporations are precluded from electing to pay the tax; but having such entities as partners/shareholders does not preclude an otherwise qualifying entity from being able to elect into paying the CA PTET.
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. The annual election to pay the CA PTET can be made without consent of all the partners, members or shareholders. The election can only be made on an original, timely filed return. Once the election is made, it is irrevocable and binding on all the qualified entity’s partners, members or shareholder. In accordance with the FAQs, guaranteed payments are specifically excluded from an entity’s qualified net income as such payments are not part of the distributive share for purposes of the PTE elective tax.
The FAQs also clarify that California resident partners calculate their CA PTET on all of the qualified entity’s resident partners calculate their CA PTET on all of the qualified entity’s net income, whereas nonresident partners, members or shareholders calculate their CA PTET on California-sourced income. Additionally, the CA PTET does not reduce the amount of the tax due below the California tentative minimum tax. The California tentative minimum tax is calculated similarly to the federal tentative minimum tax calculation. The California tentative minimum tax is California adjusted taxable income, after taking into consideration the alternative minimum tax preference items or adjustments, less the exemption amount, multiplied by 7%. Therefore, the credit can only reduce a partner’s California tax to the 7% tentative minimum tax rate. The credit limitation applies for purposes of the CA PTET even if the individual in not paying the California alternative minimum tax (which would apply if the tentative minimum tax was more than the regular tax). Finally, gain or loss on the disposition of the qualified entity (sale of partnership or LLC membership interest or S corporation stock) is considered “owner-level income” not included in the pro rata or distributive share of net income. This is in contrast to the sale of the qualified entity’s assets for a gain, which would be included in the net income of the qualified entity for purposes of the CA PTET.
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, but the actual CA PTET return can be filed on or before the extended due date. To make a payment of the CA PTET, the taxpayer must use the CA PTET payment voucher (Form FTB 3893). However, the instructions to For FTB 3893 indicate that the qualified entity can make a payment through Electronic Funds Withdrawal. If the qualified entity makes a payment through Electronic Funds Withdrawal, it will not file a Form FTB 3893. 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. However, when calculating the amount of the estimated payment(s), the qualified entity should be cognizant of the actual CA PTET that will be due. California Revenue and Tax Code Section 17052.10(d)(1)(B) states that payments made for the taxable year in excess of the calculated elective tax will be disallowed as a credit and treated as a mathematical error (and presumably the excess payment will be returned to the qualified entity as a refund). Qualified entities should consider making these voluntary payments to increase the amount of the federal deduction for taxes paid for that year. Any estimated payments made, though, are in addition to any required nonresident withholding tax payment as the California FAQ confirms that the CA PTET does not have any effect on California’s 7% nonresident withholding requirements.
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. 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.