California Adopts ‘Workaround’ to Federal Limit on State Tax Deduction for Certain Flow-Through Entity Owners | Sheppard Mullin Richter & Hampton LLP
[co-author: Nayan Karanth*]
On July 16, 2021, Governor Newsom enacted California Assembly Bill 150, allowing certain flow-through entity owners to bypass the current federal cap of $ 10,000 on state and local tax deductions (SALT) for individuals. The new law, applicable to taxation years beginning on or after January 1, 2021 and ending before January 1, 2026, allows many partnerships, limited liability companies taxed as partnerships and S-Corporations to pay an entity-level tax based on the choice of natural persons. owners share of income, then grants homeowners a California personal income tax credit for the full amount of entity-level tax paid on their distributive share of California taxable income.
Entity election and payment
An intermediary entity is eligible to make the election provided:
- Its owners are only individuals, trustees, trusts, estates or taxable entities as corporations;
- It is not a publicly traded partnership; and
- It is not allowed or required to be included in a California Combined Report.
Eligible entities that elect will pay 9.3% tax on each willing owner’s total pro-rata share of the entity’s income that is subject to California tax – for California residents, the their entire distributive share and the distributive share of Californian source income for non-residents. Individual owners can choose whether or not to consent to their income being included when an entity makes this election, and the consent of all owners is not required for the entity to make the election.
The election is irrevocable and must be made annually on a timely filed return for the year of the election. For fiscal years beginning in 2021, tax is due no later than the due date of the entity’s declaration, without taking into account any extensions. For tax years beginning from 2022 to 2025, the tax of your choice is payable in two installments: the greater of $ 1,000 or 50% of the tax paid in the previous year is due no later than June 15e of the tax year of the election, and the remaining amount is due on or before the due date of the original return (regardless of extensions).
Willing owners of electing entities can claim a credit on their California tax return equal to 9.3% of the tax paid by the entity on the owner’s share of the income subject to California tax. Surplus credits can be carried over for up to five years. Willing non-resident homeowners or part-year residents may face restrictions on applying for other California credits, including tenant credit and credit for taxes paid in other states. .
If the owner is unable to use the credit in the first year, they can carry over the credit for 5 years. California non-resident taxpayers who are residents of part of the year can benefit from this credit in its entirety. However, owners who are business entities that are not considered for tax purposes, as well as members or partners of such an entity, are specifically excluded from the right to this credit.
This election and the associated taxpayer credit can be exercised for tax years beginning on or after January 1, 2021 and before January 1, 2026; However, entities should be aware that their ability to claim this election ceases if the federal limit on SALT deductions is removed, as the law automatically repeals if this occurs. We advise taxpayers interested in this choice to contact their accountant or lawyer to determine if this choice is right for them.
The provisions expire on December 1, 2026 and are automatically repealed sooner if the federal limitation on state tax deductions is repealed.
* Nayan Karanth is a legal assistant in the firm’s Century City office.