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California’s New Passthrough Entity Elective Tax

The Tax Cuts and Jobs Act of 2017(TCJA) limited individual taxpayer’s deductions for state and local taxes paid to $10,000 per year.  In late July 2021, California approved Assembly Bill 150 which potentially offers year-end tax savings to individual owners of businesses that are treated as partnerships or S-corporations. Under Assembly Bill 150, the entity will elect to make a payment of 9.3% of the owner’s income from the business. Only Qualified businesses can make the election.  Qualified businesses are those that are doing business in California, are taxed as a partnership or S Corporation, has owners that are all exclusively corporations, individuals, single member LLCs or trusts.  In other words, if a partnership is owned by another partnership, that entity is disqualified from making the election. The election is effective for tax years beginning January 1, 2021 and before January 1, 2026.  If the business pays the elective tax by December 31, 2021, the IRS will consider this a tax deduction that will reduce the owner’s business income for the 2021 year. The entity will make the election annually on a timely filed return and each individual partner or shareholder can then elect if they want to participate. Once the business pays the elective tax, the business will issue a California tax credit to the owners. When the owners file their personal returns, this California tax credit can offset the income from the electing business. This California tax credit, however, cannot reduce California’s version of the alternative minimum tax set at 7%. Any credit that is not used can be carried forward for 5 years. Following is an example:
Partnership has income of $200,000 and 2 partners who each own 50% of the partnership.  Partnership elects to pay the tax which is 9.3% of $200,000 or $18,600.  Federal taxable income is now $181,400 or $90,700 each.  California taxable income is still $100,000 each, but each partner gets a tax credit of $9,300 to offset the taxes they owe on the $100,000 of income.
The elective tax is automatically repealed if the state and local tax limitation implemented through the TCJA is reversed.  There is pending legislation in Congress to increase the limitation to somewhere between $72,000 and $80,000 which would reduce the benefit of paying this elective tax.  We will be closely monitoring pending legislation. The HW Team is developing a tool to analyze the potential benefit from this election and reaching out to HW clients that we think may benefit from the election to discuss next steps. Please reach out to your Hayashi Wayland partner if you have questions or want to discuss California’s Pass-through Entity Tax and its application to your tax situation.