California Pass-Through Entity Tax May Have Unintended Consequences

In the past year, many states across the nation have enacted electable Pass-Through Entity (PTE) taxes in an effort to provide businesses a workaround to the state and local tax (SALT) deduction limitation that the Tax Cuts and Jobs Act (TCJA) put in place. Although in many states these PTE taxes are generally beneficial, businesses should be cautioned to the potential drawbacks in making a PTE tax election in California.

On July 16, 2021, California enacted legislation allowing eligible businesses to elect a pass-through entity tax. As such, for tax years beginning January 1, 2021, “qualifying PTEs” may annually elect to pay an entity level state tax. In turn, a “qualified taxpayer” receives a nonrefundable credit with a 5-year carryforward, for their share of the entity level tax, reducing an owner’s California personal income tax.

A qualifying PTE is an entity that is taxed as a partnership or S corporation, and such PTE is not a publicly traded partnership, an entity permitted or required to be in a combined return, or a PTE that has a partner which is designated as a partnership. As such, this latter stipulation will significantly curtail the number of PTE tax elections with respect to multi-tier flow-through structures or simply any PTE having a partner who is a partnership.

Upon the election, the tax is computed on each qualified taxpayer, which includes individuals, fiduciaries, estates, or trusts. A qualified taxpayer does not include a disregarded entity, or a corporation; but such partner entity types do not disqualify the PTE from the election. Once a qualifying PTE makes the California PTE tax election, a partner that is eligible as a qualified taxpayer is required to separately “consent” to the PTE tax election. An owner that does not consent does not prohibit the entity or other owners from making the PTE tax election. As such, if one owner decides not to consent, the PTE can still elect the tax for other owners.

The PTE tax is computed at a flat 9.3% of the distributive share of each qualified taxpayers’ income. For residents, this is all of their distributive income, while for nonresidents, this includes distributive share of California sourced income. Guaranteed payments are not considered part of an entity’s qualified income because they are not part of the distributive share for purposes of the PTE elective tax. For owners whose California effective tax rate for personal income taxes is less than 9.3%, they may find themselves in the situation with excess nonrefundable PTE credit, potentially limiting the benefit of the PTE tax election. In addition, for owners with an effective tax rate for personal income tax purposes that exceeds 9.3%, they may still need to consider their entire tax profile holistically, as if such owner has losses from activities unrelated to the electing PTE, this could potentially result in the inability to use PTE credits, possibly limiting the benefit of the PTE tax election.

Perhaps businesses may be alarmed to find out that the California Franchise Tax Board recently updated its FAQs to clarify that the PTE credit does not reduce the amount of California tax below the “tentative minimum tax” (TMT). As such, even if an owner’s regular tax exceeds TMT, the PTE credit can only be used for the amount that the regular tax exceeds TMT. The TMT is computed by adjusting California income subject to certain adjustments, at a 7% tax rate.Without a legislative fix, an electing PTE’s owner on an annual basis may forgo significant PTE credit, which could significantly nullify the benefit of a PTE election. With that being said, some businesses may want to consider frontloading their PTE opt-in (and credit), whereby they elect in Year 1, and abstain from electing in subsequent years in order to monetize the election. This requires the owner not to have losses from other activities that otherwise reduce the monetization of such credit and requires assurances that such owner will recognize comparable income levels in years subsequent to the election. This would create a timing difference between when the PTE tax is paid and when the credit may be fully utilized, essentially resulting in an interest-free loan to California. Even if a PTE attempts to use the “frontloading” strategy to take advantage of the election, businesses need to be cautioned that in a year with significant income such as capital gains stemming from a transaction, the 5 year carryforward limitation could inhibit the PTE from yielding a benefit from the election.

The PTE tax requires estimated payments for tax years beginning with 2022, with 50% due June 15thof the taxable year of the election, and the remaining balance due by the original due date of the return (March 15th). However, the legislation requires that in order to make the PTE election, the first estimated payment installment must be made. Based on such provision, businesses would need to decide if they are proceeding with the election by June 15thof the taxable year, opposed to the return due date. Furthermore, businesses that make the PTE election are still subject to withholding requirements on nonresidents, resulting in duplicate tax payments. This requires multiple payments in order to secure the benefit, while having owners wait to receive a refund on their personal tax return.

Businesses taxed as S corporations also need to be prudent with having certain shareholders consent into the tax, while other shareholders declining the consent. This lack of election uniformity could possibly create a “second class of stock” under S corporation rules and may possibly invalidate S corporation treatment.

Let’s Discuss PTE

For many businesses, in many states, PTE tax elections are yielding significant tax benefits. PTE election decision making requires modeling and analysis of the specific facts and circumstances to weigh the potential benefits along with the risks in determining the right course of action. As the current law stands, the California PTE tax has many flaws, and such election could have unintended consequences. As such, businesses are strongly advised to carefully consider these limitations before electing into the California’s PTE election.

In addition, for businesses which determine that a PTE tax election may be advantageous, nonresident California owner demographics need to be considered. With the election shifting the tax burden from the owner to the PTE, there may a risk of loss of resident credits in owner’s home states, potentially negating the benefit of such election. On the flip side, due to California’s lack of guidance, a business electing into another state’s PTE with California residents will be faced with uncertainty if their share of the resident credit would be usable. With proper planning and strategy implementation, some businesses may benefit from the California PTE tax election, but it is strongly advised all the potential drawbacks are considered before making a PTE tax election.

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If you would like to discuss how Pass-Through Entity taxes may impact you, then contact Withum’s State and Local Tax Team for a deeper conversation.