AB 150 – California’s Creative Solution to the State & Local Tax Deduction Limitation
The goal of every taxpayer is to minimize their tax liability legally. When federal tax laws repeal or limit deductions, sometimes states step in to provide relief. Before the Tax Cuts and Jobs Act (“TCJA”) was enacted in December of 2017, individual taxpayers could deduct state and local tax they paid as an itemized deduction on their personal tax returns. The TCJA capped this deduction at $10,000 in total. Many high-tax states, such as California, sought to create legislation to provide relief from this significant change to the federal tax code. In this article, we will discuss California Assembly Bill 150, California’s response to the TCJA that effectively reinstated the full benefits of the state and local tax deduction.
AB 150 was signed into law on July 16, 2021. AB 150 made several changes to the California Revenue & Taxation Code. The one discussed in this article is the addition of the Small Business Relief Act. Beginning in January 2021, the Small Business Relief Act allows certain qualified entities to elect to pay and deduct a pass-through entity (“PTE”) tax of 9.3% of qualified income. The elective tax is an entity-level tax deductible for federal tax purposes. On the state level, the PTE’s owners get a nonrefundable credit for the amount equal to the owners’ share of the elective tax paid. The owners can then use this credit to reduce their personal income tax bill. If the owners’ tax bill is less than the amount of the credit, the owners can defer the unused credit for up to five years. When owners deduct the elective tax paid by the PTE on their personal income tax return, they are, in effect, receiving a deduction that exceeds the $10,000 SALT limit imposed by the TCJA. The IRS has approved this treatment in Notice 2020-75.
The Small Business Relief Act allows only qualified entities to pay the elective tax. Qualified entities are pass-through entities taxed as partnerships or S corporations, including LLCs taxed as partnerships and LLCs taxed as S corporations. However, it does not include publicly traded partnerships or an entity permitted or required to be in a combined group. A qualified taxpayer is the entity’s member or shareholder who is either an individual, fiduciary, estate, or trust subject to California personal income tax. Hence, the member or shareholder cannot be a corporation, a partnership, or a disregarded business entity and its partners and members, except for a disregarded single-member LLC. So even though a partnership is eligible to pay the elective tax, the partner will not be able to utilize the tax credit if the partner is a corporation, for example.
To take advantage of the new deduction and credit, an irrevocable election is made on an original, timely filed tax return. Note that each member of the PTE shall make their election separately, so the entity’s members can elect differently. For tax years beginning after January 1, 2022, and before January 1, 2026, the elective tax is due in two installments as follows: 50% of the elective tax paid for the prior taxable year is due by June 15th of the taxable year of the election and the balance due by the due date of the original return, without regard to extension.
The following example shows the potential benefits of utilizing the new entity-level tax and credit system under California law:
Q&A partnership is a California LLC that is taxed as a partnership. Q&A has two members, each owning 50% of the business. In 2022, Q&A had $ 2,000,000 in net taxable income; each partner received his share of $1,000,000 in taxable income.
Without the benefit of the Small Business Relief Act, the tax liabilities would be calculated as follows:
Each partner’s California tax liability will be $93,246 (calculated at 11.3% for the amount over $750,443). In addition, each partner’s federal tax liability will equal $ 306,523 (calculated at 37% for the amount over $628,300). The total taxes paid by each partner is $ 399,768.93. Remember that this hypothetical assumes the partner is filing jointly and assumes the SALT cap of $ 10,000 has already been used.
Taking advantage of the new elective tax and credit, the partners can significantly reduce their overall tax liability as follows:
If Q&A makes the timely election, the entity will pay the 9.3% PTE tax on the $2,000,000 of taxable income or $186,000. Each partner can now make a deduction of $93,000 as an offset against their income on the federal tax return. As a result, each partner will end up with $907,000 of taxable income for federal tax purposes (1,000,000 – 93,000). By doing the calculations, each partner’s federal tax bill will equal $ 272,113. In California, each partner will report $1,000,000 of taxable income. As a result, the partner’s tentative tax bill will equal $ 93,246. At this point, the partner can apply credit earned from the elective tax and reduce the tax bill to $ 246 only (93,246 - 93,000). By paying the elective tax, the total tax paid by each partner is $365,359. That is $34,410 less than what the partner would have paid had they not made the election!
As mentioned above, this technique was effectively blessed by the federal government when the IRS issued notice 2020-75, inviting states to implement elective tax pass-through entities. As with any legislation, you must be aware of certain caveats to the Small Business Relief Act. First, for an entity to benefit from this tax saving for 2022, it must have made the election and paid the first installment of the tax on June 15th, 2022 (accordingly, taxpayers making this election for the first time may have to wait until 2023). Second, S corporations should carefully evaluate the situation, especially when not all shareholders choose to pay the elective tax. The law does not require all entity members to make the election; this, however, may create a problem with the second class of shares in an S corporation, which eventually may lead to losing the preferable tax status of an S corporation. Lastly, S corporations are also subject to a 1.5% annual tax in California which is not substituted by the elective tax. Therefore, this should be considered when calculating the potential tax savings from paying the elective tax.
Utilizing the elective tax and credit plan provided by the adoption of the Small Business Relief Act is an innovative technique that can work around the SALT deduction limitation by those who qualify. However, each case should be evaluated separately. If you have any questions about the Small Business Relief Act and this tax-saving strategy, please contact your accountant or a qualified tax attorney.