Article
California passes law to allow federal income tax relief for pass-through entity owners
Aug. 8, 2021 · Authored by Glenn Walsh, Chris Parker, Lawrence Khan
On July 16, 2021, California Governor Gavin Newsom signed into law Assembly Bill (AB) 150, the Small Business Relief Act.
This Act allows limited liability companies (LLC), S corporations, and partnerships — also known as pass-through entities (PTE) — the opportunity to claim a state income tax deduction on their federal income tax return for taxes paid to California.
Understanding the new law
Currently, the Internal Revenue Code (IRC) places significant limitations on state tax deductions for individuals. California’s new law provides a workaround to this limitation by allowing a PTE to make an election to pay California income tax at the entity level.
Specifically, the election creates a deduction on the PTE’s federal income tax return because the state taxes paid by the PTE reduce the federal taxable income that its electing owners report on their federal income tax return. An electing taxpayer receives a California tax credit for the tax paid at the entity level, which can offset their California individual income tax obligation.
If this election is made, qualified PTEs calculate the entity-level tax using a fixed tax rate of 9.3%. Taxpayers subject to higher income tax rates — California’s highest personal income tax rate is currently 13.3% — will need to pay any additional tax due with their individual return.
Defining qualified entities
AB 150 allows only a qualified entity to elect to pay income tax on the entity’s net income for the taxable year. A qualified entity is an entity taxed as a partnership or S corporation. Therefore, a general partnership, limited partnership, or LLC that’s taxed as a partnership could be a qualified entity while a publicly traded partnership can’t be a qualified entity.
Additionally, a qualified entity can only be owned by corporations, fiduciaries, estates, trusts, or individuals. Therefore, a PTE isn’t a qualified entity if its ownership group includes a disregarded entity, a partnership, or a corporation that’s a member of a combined reporting group or eligible as a member of a combined report for corporate tax.
As a result of these limitations, a careful review with a tax advisor of the PTE’s organization structure, including the composition of its ownership group, is recommended. For example, where a legal entity structure includes tiered partnerships or disregarded entities, additional organizational planning will likely be required for those entities wanting to participate in this opportunity.
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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.