By Neil McCarthy, CPA – Tax Manager at Lindsay & Brownell
Background on the SALT Workaround
Federal tax reform in 2017 established a limit, or “SALT cap,” on the amount of state and local taxes that could be deducted by individuals. The SALT cap is currently $10,000 for both single and married filing joint filing statuses, and is scheduled to sunset after the 2025 tax year.
Many states, including California, considered legislation that would mitigate the effect of the SALT cap. IRS promulgated guidance that they would challenge these workarounds; however, on November 9, 2020, IRS issued Notice 2020-75 stating their position that would not challenge an approach first adopted by Connecticut. This approach, which is available to owners of passthrough entities (“PTEs”), has two components: an optional entity level tax on the PTE; and a corresponding credit by the owners of the PTE.
Since the tax is assessed at the entity level and the SALT cap does not apply to entities, this permits the PTE to fully deduct the state tax for federal tax purposes. This flows through to the individual owners as a reduction to AGI, bypassing the SALT cap.
California SALT Workaround
Overview. The California legislature passed AB 150, which includes the SALT Workaround, on July 5, 2021 and the Governor signed it into law on July 16, 2021. Under AB 150, qualifying PTEs can elect to pay a 9.3% income tax and owners of the entities who pay personal income tax can claim a credit equal to the tax the entities pay. The election is available for the 2021 through 2025 tax years but will be eliminated sooner if the federal SALT cap is repealed.
About the Election. The election is an annual election and, once made, is irrevocable and binding on all owners of the PTE. The election is made on an original timely filed return.
Who is a Qualifying PTE? A PTE qualifies if it is an entity taxed as an S corporation or partnership and has exclusively corporations, individuals, trusts or estates as owners. A PTE does not qualify if it is publicly traded, subject to combined reporting, or is owned by one or more partnerships.
Tax Calculation. The tax is 9.3% of qualified net income which includes 100% of the distributive share for California residents, and only the California-source portion for nonresidents. While a partnership can elect the SALT Workaround if it has owners which are corporations, the tax is not assessed on corporations’ share of distributive income; it only applies to individuals, trusts and estates.
Payment of Tax. For taxable years beginning on or after January 1, 2021 and before January 1, 2022, the PTE tax is due on or before the due date of the return without regard to extensions. For taxable years beginning on or after January 1, 2022 and before January 1, 2026, the PTE must pay $1,000 or 50% of the elective tax paid in the prior year, whichever is greater, by June 15th of that year and pay the remaining tax due for the year by the due date of the return without regard to extensions. If the required payment is not made by June 15th, the entity can not elect to apply the tax for that year.
Credit. AB 150 allows a credit against net tax to the qualified taxpayers of the electing PTE. The amount of the credit is equal to 9.3% of the qualified taxpayer’s distributive share of qualified net income subject to the PTE election. If the credit exceeds the taxpayer’s net California income tax, the excess is not refundable; instead, it is carried forward for up to five years.
Benefits. Since an entity’s state tax deduction is not subject to the SALT cap, electing the SALT Workaround allows taxpayers to bypass the SALT cap to the extent of the tax paid by the PTE. In addition, the elective tax payment due dates contrast favorably to estimated tax payment due dates for individuals.
If you have any questions, please reach out to your L&B advisor!