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California expands the passthrough entity tax

The passthrough entity tax is a workaround for the $10,000 individual income tax limit on the deduction for state taxes adopted in the Tax Cuts and Jobs Act of 2017. Oversimplified, the IRS says certain state taxes paid by a passthrough entity (partnership, LLC taxed as a partnership, or S corporation) with a state tax credit passed through to owners of the entity are tax deductible.

Last year, California adopted an elective passthrough entity tax as part of AB 150 (July 16, 2021.)

There were a number of issues with that legislation, including a provision that the Passthrough Entity Elective Tax Credit couldn’t reduce California individual tax below the alternative minimum tax.

On February 9, 2022, Governor Newsom signed SB 113, which fixes some of the issues, including:

  • Repealing the tentative alternative minimum tax limitation for the Passthrough Entity Elective Tax Credit;
  • Allowing partnerships and limited liability companies taxed as partnerships with owners that are partnerships to make the election, although the tax can’t be paid on behalf of an owner that is a partnership;
  • Allowing Single Member Limited Liability Companies (SMLLCs) that are passthrough entity owners to claim the Passthrough Entity Elective Tax Credit (the credit is claimed on the income tax return for the individual owner of the SMLLC);
  • Effective for tax years beginning January 1, 2022, the credit ordering rules are changed so that the Passthrough Entity Elective Tax Credit is applied to state income taxes reduced by credits for income taxes paid to other states (the benefit of the state tax credit isn’t lost and any unused Passthrough Entity Elective Tax Credit is carried over up to five years);
  • Certain guaranteed payments made to a partner are eligible for the passthrough entity tax.

Note that Single Member LLCs still aren’t eligible for the election to pay a passthrough entity tax for their own income.

SB 113 also includes other federal tax conformity provisions.

  • Conforms to the federal exclusion for Restaurant Revitalization Grants, retroactive to the 2020 tax year;
  • Partially conforms to the federal exclusion of Shuttered Venue Operator Grants, retroactive to the beginning of the 2019 tax year; and
  • Repeals the $5 million business credit limitation and net operating loss suspension for higher income taxpayers for the 2022 tax year.

Note that taxpayers who are eligible for these benefits might have to file amended California income tax returns.

See your tax advisor for more details.

Here is a link to read the bill.

Tax and financial advice from the Silicon Valley expert.