Updates to the California Pass-Through Entity Elective Tax

Recently, in Senate Bill 113 (SB 113), California made some welcome changes to the California Small Business Act which promulgated the California Pass-Through Entity Elective Tax (CA PTEET). The changes made by SB 113 were retroactive to 2021 and removed some of the deterrents that businesses were addressing when deciding whether to elect to opt into paying the CA PTEET. With some of the pitfalls removed, the CA PTEET is now a very viable option for qualified pass-through entities.

The main changes that were made to the CA PTEET in SB 113 are as follows:

• A qualified pass-through entity is not disqualified from making the election to opt into paying the CA PTEET because it has a partnership as a partner, shareholder or member.
• Guaranteed payments are now included in the tax and credit calculation.
• The CA PTEET credit has been added to the list of credits that may reduce the net tax below the California tentative minimum tax.
• An otherwise eligible business entity can have a disregarded single member limited liability company (LLC) as a partner, shareholder or member if the disregarded entity is owned by an individual, trust or estate that consents to have the sum of their guaranteed payments and pro rata share of distributive share of income subject to the CA PTEET.
• For 2021, the CA PTEET credit is applied before the credit for taxes paid to other states, while in 2022 and thereafter, the CA PTEET credit is applied after the credit for taxes paid to other states.

Although these modifications removed some of the main limitations with the original version of CA PTEET, the CA PTEET credit is still a nonrefundable credit with a five-year carryforward. This may impose a challenge to eligible partners, members or shareholder who may not have income in the future years to offset the credit carryforward. Additionally, starting in the 2022 tax year, the eligible entity must make a June 15 estimated tax payment of the greater of 50% of the prior year tax liability or $1,000 in order to be allowed to make the election. This estimated tax payment will be made months before the actual election due date, which is the due date of the return including extensions. If a qualified entity makes the estimated tax payment and then later decides not to elect opt into the CA PTEET, California will presumably refund the estimated tax payment to the entity.

California has released its Forms 3804 (Pass-Through Elective Tax Calculation) and 3804-CR (Pass-Through Entity Tax Credit) and published instructions with those forms. However, those instructions do not include all of the changes listed above and should not be relied upon at this time. California will be issuing revised instructions.

The CA PTEET is a welcome addition to the number of states that have already passed a pass-through entity tax. Given the high tax rate of 9.3%, the CA PTEET is now something that should be seriously considered when conducting tax planning for pass-through entities and their owners.