On July 16, 2021, Governor Newsom signed California Assembly Bill 150 into law. Along with other provisions, AB 150 allows certain owners of passthrough entities a way around the current Federal cap of $10,000 for state and local tax deductions for individuals. Prior to the Tax Cuts and Jobs Act (TCJA), taxpayers were able to deduct 100% of the state and local taxes they paid including income taxes and property taxes. In late 2017, the TCJA was passed which limited this deduction to $10,000 total.
For example, if your annual property taxes were $12,000 and your California income taxes were $10,000: Prior to TCJA you could deduct $22,000, but after TCJA you can only deduct $10,000. This change resulted in the loss of a deduction of $12,000. AB 150 is California’s solution to minimize the tax impact of this limitation.
What is AB 150?
California Assembly Bill 150 establishes the Small Business Relief Act which allows qualified passthrough entities to elect to pay and deduct a California passthrough entity tax of 9.3% on qualified net income. This elective tax is an entity level tax that is deductible by the entity for Federal tax purposes (as confirmed in IRS Notice 2020 -75). By deducting the tax at the entity level, the benefit of the tax is passed on to the individual partner and reduces their overall tax. The new law is effective for years beginning on or after January 1, 2021 and ending before January 1, 2026. This elective tax will expire on December 1, 2026 unless Federal law changes prior to that date upon which the law is automatically repealed.
Who benefits from AB 150?
Qualified entities including Partnerships, S Corporations and LLC’s filing as partnerships can make an irrevocable election on an annual basis to utilize this tax. Qualified entities do not include publicly traded partnerships, entities required to be in a combined reporting group and an entity that has a partnership owner. Qualified entities make the annual election and each individual owner can choose if they want the entity to pay the tax on their share of the entity’s income.
How does it work on the passthrough entity return?
The election is irrevocable and must be made annually on a timely filed return for the year of election. For tax years beginning in 2021, the tax is due on or before the entity’s return due date, without regard to extensions. For tax years beginning in 2022 through 2023, the elective tax is due in two installments: the greater of $1,000 or 50% of the tax paid in the prior year is due by June 15th of the taxable year of the election and the remaining amount is due on or before the due date of the original return (without regard to extension).
How does it work on the partner or shareholders return?
Consenting passthrough owners claim a nonrefundable credit on their personal income tax return equal to the elective tax paid on their behalf by the entity (9.3% of their qualified net income). Unused credits can be carried forward for up to 5 years. Nonresidents and part-year residents are able to use the entire credit (i.e. no proration of their flow thru income to their total income)
Fun and Games Partnership has two 50% partners, and the partnership has $800,000 of income. Without AB 150, the owners of Fun and Games each pay tax on $400,000 at CA tax rate of 9% for a total of $36,000 of tax each. This tax is not deductible for Federal tax purposes, so they also pay $120,000 of Federal tax each ($400,000 at 30%). (Assuming they already deduct up to $10,000 each of property taxes.)
With AB 150, Fun and Games Partnership pays tax to CA of 9.3% each or $37,200 each. This tax is deductible for Federal tax purposes, so they now pay Federal tax on $362,800 ($400,000 – $37,200) each for a total of $108,840 ($362,800 @30%) each. Total tax paid per partner is now $146,040 compared to $156,000 each, prior to AB 150, for a tax savings of $9,960 per partner.
How do I know if this applies to me?
Every California Partnership, LLC taxed as a Partnership and S Corporation will need to determine if they qualify to make the election to be taxed at the partnership level. Second, if the partnership qualifies, then an analysis will need to be done to determine if the election will result in tax savings to any of the partners. And third, each individual partner will need to determine whether they consent to the election or want to pay tax at the individual level.
AB 150 can result in significant tax savings, but specialized analysis is necessary to determine if there will be a benefit to the individual owners.
As always, please do not hesitate to contact the HW partner or team member you work with for assistance or with any questions you may have.