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California Enacts Significant Pass-Through Entity Tax Changes

Like many states across the country, California enacted an elective pass-through entity tax (“CA PTE Tax”) effective for tax years beginning on or after January 1, 2021. The goal of the CA PTE Tax is to circumvent the $10,000 cap on state and local tax deductions available to individuals for federal income tax purposes.

While the CA PTE Tax was intended to be taxpayer-friendly, it created several technical issues due to how the law was drafted and subsequently interpreted by the California Franchise Tax Board (“FTB”). This made electing into the CA PTE Tax detrimental to many taxpayers.

In an effort to correct the various technical issues, Governor Newsom signed new legislation which makes a series of business-friendly tax changes to the state’s PTE Tax including:

  • Beginning in tax year 2021, the CA PTE Tax credit which flows through to shareholders, partners, and members of an electing PTE may now reduce the taxpayer’s total California personal income tax below the tentative minimum tax (generally 7 percent). This represents a major change and benefit to California personal income taxpayers. The previous “net tax” limitation significantly cut into the federal tax benefit available from the election.

  • Beginning for tax year 2022, the CA PTE Tax credit will be claimed after the credit for tax paid to other states. Again, this change can significantly benefit electing CA PTE business owners if their entities are engaged in multistate activities.

  • Guaranteed payments subject to CA personal income tax can be included in the CA PTE Tax base beginning in tax year 2021. This change represents another significant benefit to electing PTE owners that was not available under the prior legislation. California guidance calls for guaranteed payments to be apportioned in the same manner as an electing PTE’s regular business income in the case of nonresidents.

  • Single member entities that are owners of an electing PTE may now be included in the definition of a “qualified taxpayer” if the entity is owned by an individual or trust who has consented to have their California taxable income subject to the CA PTE Tax. This change takes effect for tax year 2021. It allows for income allocated to these eligible single member entities to be included in the CA PTE Tax base and also makes them eligible for the CA PTE Tax credit.

  • An electing PTE can now have a shareholder, partner, or member treated as a partnership beginning in tax year 2021. While this changes the eligibility rules for the PTE Tax, any PTE taxable income allocated to another partnership will continue to be ineligible for inclusion in the PTE Tax base, and will not generate a resulting PTE Tax credit.

To summarize, the California PTE Tax changes are very favorable and eliminate many of the issues and challenges associated with electing into the original PTE Tax regime. It is important to note that one of the unique aspects of the CA PTE Tax is the ability for individual PTE shareholders, partners, or members to opt-in or out of the elective regime. This concept, coupled with the increased flexibility of ownership and structure afforded under the new law, makes the new PTE Tax regime more workable and accessible for PTEs and their owners.

Finally, while not related to the PTE Tax, this new legislation also eliminates any net operating loss suspension and the $5 million limitation on business tax credits for tax year 2022.

Please reach out to your Citrin Cooperman State and Local Tax Practice professionals to discuss the opportunities provided by the new legislation.  

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