AB 150 & The Pass-Through Entity Tax: What California Business Owners Need To Know
In 2021, the state of California passed Assembly Bill 150 (AB 150), which included the Small Business Relief Act (SBRA). Since then, many states have followed suit, although laws differ from state to state.
Because of the SBRA (and subsequent amendments via SB 113), California partnerships and S-Corps can opt to pay California income tax at the entity level and pass on the federal deduction to consenting company owners, who are then eligible to receive a California tax credit.
The SALT Cap: Why a Pass-Through Entity Tax Was Needed
Let's zoom out for a bit more context. In 2017, the Tax Cuts and Jobs Act passed a $10,000 cap on what state and local taxes (SALT) could be deducted. This is referred to as the "SALT cap."
Naturally, that spurred business owners to begin thinking about workarounds. A series of legislation was initiated, culminating with AB 150 and the passage of the Pass-Through Entity Tax (PTET).
Under AB 150, "Qualified Entities" in California are eligible to pay a 9.3% state income tax on any state-sourced income of "Qualified Taxpayers" from 2021-2025. Because the federal deduction for state income tax is not subject to the SALT cap, that reduces the Qualified Entity owners' taxable income.
Before we continue, some definitions are in order:
A "Qualified Entity" is any entity taxed as a partnership or S-Corp (with the exception of publicly traded partnerships and entities belonging to combined reporting groups).
A "Qualified Taxpayer" is a person, fiduciary, trust, or estate subject to state personal income tax who consents to their inclusion in the qualified net income.
Qualified taxpayers also receive a credit against their state income tax liability based on their share of the Qualified Entity's income. You'll notice the definition mentions "consent"—only the Qualified Taxpayers that give permission are included in the qualified net income for the Qualified Entity.
How To Leverage PTET For Your Company
The language around this legislation is complex and has different implications, depending on whether you're a partnership or S-Corp. We strongly recommend working with a CPA to understand how PTET applies to your business.
Here are a couple of noteworthy things about AB 150 and subsequent amendments:
You make your PTET election each year on your tax return. Once you decide, that decision is binding.
What "consent" means is uncertain and has been debated; it may make the most sense to provide written consent until further details are released.
For tax years 2022 forward, PTET is due in two payments, with the first due in June and the second due the following March.
There is no tentative alternative minimum tax limitation; if you owe a tentative minimum tax, you can still reduce your tax liability by the amount of the PTET credit.
The PTET credit is applied against the net tax after credits for other state taxes are applied.
Any amount of the tax credit which isn't used can be carried forward, but you may lose the credits when PTET expires after 2025.
Underpayments can affect your ability to elect PTE in future years, making it critical to pay the right amount on time.
Ultimately, whether or not it makes sense to elect into PTET depends on your company, your partners and shareholders, and other factors. It requires careful planning and implementation of a sound strategy to take full advantage of the PTET election without any unintended consequences.
If you're interested in taking advantage of the PTET or learning more about the potential benefits of PTET for your business, reach out to Modis Advisors today. We'll help you understand how this legislation applies to you and ensure that your taxes are filed before the necessary due dates.