CA Tax Credit for Pass-Through Entities (Deadline 3/15/22)
Special Tax Credit for Pass-Through Entities
A new tax credit is available to California (CA) taxpayers who own an interest in a “pass-through entity” such as a partnership or an S-Corporation. This credit, known as the Pass-Through Entity (PTE) tax credit, is a way for businesses to pay CA state income tax on behalf of the owners and avoid the $10,000 state and local tax (SALT) deduction limit on their federal returns.
However, there are qualifying restrictions and the credit may not benefit all business owners.
Due to the interplay between individual and business tax returns, this tax credit requires careful tax planning before the election is made -- by the March 15th business tax extension deadline.
How it Works
Pass-through entities taxed as a partnership or an S Corporation are allowed to pay an additional elective tax at the entity level in an amount equal to 9.3% of an owner's pro rata share of the net income subject to the election. A qualified owner of the entity who makes this election is then allowed to apply their share of the tax credit against their personal CA tax liability.
Limitation for “Tentative Minimum Tax”
As currently written in tax law, the credit cannot reduce what is known as the “CA tentative minimum tax” for the individual claiming the credit. In order to determine if this credit would be beneficial, the taxpayer must estimate both the CA income tax and the CA tentative minimum tax.
Here is are two very simplified examples:
In both cases you are a shareholder of a qualified S corporation.
1. Your business flow-through income from this S corporation in 2021 is $100,000.
You consent to have the S corporation pay the 9.3% tax on your share of income. The S Corp submits a payment to the Franchise Tax Board of $9,300, and claims a business deduction against its federal taxable income. Your 2021 Schedule K-1 will report this credit amount for you to claim on your personal tax return. Your 2021 CA regular income tax on all your income is $25,000 and your CA tentative minimum tax is $15,000. You are taxed on the higher amount – in this case, the regular income tax. You would be able to reduce your CA regular income tax by the full amount of $9,300 credit since it is higher than the minimum tax by $10,000.
2. Let’s say, instead that your CA regular income tax is $20,000 and your tentative minimum tax is $16,000. You could only utilize $4,000 of the PTE credit. The balance of $5,300 would carry forward to the next year.
Timing of Deduction and Credit to Owner
The tax savings benefit is available in the year that the tax is paid. If the election is made for 2021 and the company pays the tax in 2022, you will not see this reduction in income on your 2021 Schedule K-1 but on the 2022 Schedule K-1. However, you WILL get the tax credit on your 2021 Schedule K-1 and on your 2021 CA income tax return (subject to the tentative minimum tax limitation mentioned above).
If you make this election for both 2021 and 2022, and the entity pays the tax for both tax years during 2022, your Federal flow-through income will be reduced in 2022 for both payments thus lowering your Federal taxable income (the deduction does not impact CA taxable income.)
Additional Pending Changes
There still could be changes made to the application of the credit.
In his annual budget proposal last month, Governor Newsom proposed two changes that he would like the legislature to take up before March 15, 2022 so that they could apply to 2021:
- (Proposed) Make the individual credit apply to the tentative minimum tax as well as the regular tax, thereby eliminating the extra complexity
- (Proposed) Make the election available to disregarded entities such as single member LLCs.
There has been a bill proposed in the CA legislature, but we do not know when it will be discussed, or when/if it will even be passed.
This tax credit could provide a significant benefit to you, but its complexity means it will require careful tax planning and tax projections before the election is made.
Please contact your tax preparer if you are interested in pursuing this potential benefit for the 2021 tax year.