The Tax Cuts and Jobs Act (TCJA) passed in late 2017 put a $10,000 limit on the amount of state taxes individuals could subtract as itemized deductions. As a workaround, some states have enacted legislation to allow certain pass-through entities (PTEs) to be taxed at the entity level for state taxes. This allows PTEs, such as S corporations and partnerships, the ability to deduct their tax payments at the federal level as a business expense. This essentially bypasses the $10,000 deduction limit at the owner level. The taxes paid by the PTE is then a state credit which can be used to offset state taxes due on the owner’s tax return.
On July 16, 2021, California Governor Gavin Newsom signed Assembly Bill 150, allowing this workaround for S corporations and partnerships for tax years beginning on or after January 1, 2021. Certain PTE’s can elect to pay 9.3% income tax. For tax years beginning in 2021 the election must be made on a timely filed return, and is irrevocable for that year. Each owner within an eligible PTE can consent to have their share of income subject to the PTE tax. If an owner does not consent, it doesn’t preclude other owners from making the annual election to pay the tax. The tax withheld will be computed based on the electing owner’s distributive share of pass-through income.
The IRS gave its stamp of approval to these types of PTE taxes in IRS Notice 2020-75, and stated that they intend to issue regulations to clarify the treatment of taxes on both the entity’s and owners’ returns. The notice appears to state that the passthrough entity would deduct the tax in the year the tax is paid. So in order to get a deduction in 2021, as of now it appears that the 9.3% tax must be paid by 12/31/21.
The extent of the benefit will need to be analyzed carefully for each individual’s tax circumstances for 2021. This is because the law is currently written in a way which prevents the credit from being used beyond the tentative minimum tax. It appears that this was not the intent of the legislation, but this technical glitch will need to be corrected through a legislative change in order to allow the PTE credit to fully offset TMT as well as regular tax. Note that the credit is allowed to be carried over for 5 years, so planning will be required to ensure it can be fully utilized.
If you would like to do some analysis to measure the potential benefit of making the 9.3% tax payments at the entity level by 12/31/21, please contact our office as soon as possible. It will take time to plan and make payments before the end of the year, so we don’t want to delay and potentially miss out on the full benefits.
Dana R. Borys, an Accountancy Corporation is a boutique tax consulting, compliance, and representation firm working with affluent individuals and owners/officers/founders of start-up/emerging growth companies. Building connections beyond the code.