Using The AB-150 Pass-Through Entity Elective

If you are a Qualified Taxpayer of a Qualified Entity who routinely pays more than $10,000 in state and local taxes and more than 9.3% in California Income Taxes on your K-1 income, the Pass-Through Entity Elective Tax may be an effective tax mitigation strategy for you.

In July of 2021, California passed Assembly Bill 150 which contains, among other things, the Small Business Relief Act, joining a host of other states that passed similar legislation to create a workaround for the current $10,000 deduction limitation for state and local income taxes (SALT) established by the Tax Cuts and Jobs Act of 2017.  The Pass-Through Entity Elective Tax is in effect for 2021-2025.

How it works: The AB-150 Pass-Through Entity Elective

Qualified California pass-through entities that issue a K-1 (defined below) can make an election to pay a flat state income tax of 9.3% at the entity level on their qualifying owners’ (“Qualifying Taxpayers”) share of the pass-through income and receive a tax credit of the same amount for a dollar-for-dollar reduction of the state income tax due at the individual level. The state tax at the entity level will reduce the amount of Federal K-1 income passed through to the K-1 recipient which could potentially reduce Federal AGI in an amount greater than what can be achieved via a state income tax deduction on Schedule A due to the $10,000 limit.

That’s the SALT workaround: reduce the amount of Federal Income passed through to the K-1 holder thereby lowering taxable income rather than taking a deduction for state income tax paid on Schedule A to lower taxable income. While this might sound like a no-brainer, the devil is in the details when it comes to taxation, and here are the details as we know them today. First, your company must be a Qualified Entity to make the election:  S Corp. Partnership, or LLC (taxed as an S Corp or partnership), but only if: No Owners are partnerships; Not allowed to be in a combined return; Not publicly traded. Single-member LLCs and Living Trust owners do not qualify. Secondly, you must be a Qualified Taxpayer to make the election: Must be an individual, trust, or estate subject to California personal tax; No corporations or disregarded business entities.  The 9.3% tax is assessed on Qualified Net Income: Pro-Rata share or distributive share of all income (including interest, dividends, and capital gains) of the entity’s individual, trust, or estate owners that consent. Not all owners have to consent; Income is subject to California tax; Guaranteed payments are not included. Other details: Qualified taxpayers get a nonrefundable personal income tax credit on the California return for the year it is elected; Election must be made annually, is irrevocable, and can only be made on timely filed returns, including extensions.

For Federal purposes, Cash-based taxpayers deduct the tax the year it is paid.  For Accrual based payers, formal guidance has not been received so we are recommending for 2023 that both accrual and cash taxpayers pay the tax payments as follows: Payments for 2022-2025, taxpayers must make 2 payments: The first is to be paid via estimate by 6/15 (Extended to 10/16 this year) of each year. The remaining amount due must be paid by the entity’s original filing date deadline of 3/15/24.

5-year carry forward for unused credit; S Corps and partnerships that elect to pay will have to make compensating distributions to owners who don’t elect to pay the tax; S corps should be particularly wary of this as it might be viewed as creating 2 classes of stock, resulting in a lost S election.

Credit will not reduce the California tax below the Tentative Minimum Tax which will limit taxpayers with gross business receipts over $1 million.

The Bottom Line

The bottom line is that if you are a Qualified Taxpayer of a Qualified Entity who routinely pays more than $10,000 in state and local taxes and more than 9.3% in California Income Taxes on your K-1 income, the Pass-Through Entity Elective Tax may be an effective tax mitigation strategy for you.  But, as shown above, it’s complicated.  The best way to determine whether you are a candidate for this election is to talk to your tax professional at Tax Plus and have us run some tax analysis for you.

Resources: CA Assembly Bill 150; FTB Tax News; Spidell’s Quarterly Tax Update; EY Tax News Update.