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California: 2022 Legislative Updates Including PTE Tax Mechanics & Related Credits
In California, eligible pass-through entities may elect to pay California income tax at the entity level for taxable years beginning on or after January 1, 2021, and before January 1, 2026. The rate used to calculate California’s elective tax is a flat 9.3 percent. The election is made on an annual basis and provides a corresponding tax credit at the qualifying owner level. The idea behind the pass-through entity-level tax (PTET) is to allow qualifying, eligible owners to bypass the $10,000 state and local tax deduction cap limit established by the Tax Cuts and Jobs Act.
However, when California Gov. Gavin Newsom signed Assembly Bill 150 (AB150) in 2021 establishing California’s PTET, it came with several unpredicted problems. California is one of a few states with a tentative minimum tax (TMT) system designed to prevent taxpayers from avoiding taxes by limiting tax benefits and deductions. The language in AB150 limited the allowable PTET credit by not letting the credit reduce the owner’s California income tax below the TMT; therefore, California taxpayers claiming a PTET credit would not be able to reduce their liability beyond the TMT’s current 7 percent tax rate. AB150 also restricted pass-through entities from being PTET-eligible if their owners included partnerships or disregarded entities and excluded specified guaranteed payments in partnership structures from being treated as income subject to the PTET calculation.
To remedy these shortcomings, Newsom signed Senate Bill 113 (SB113) on February 9, 2022. SB113 made the following changes:
- Allows the PTET credit to reduce the regular tax below the TMT
- Includes partnerships, LLCs taxed as partnerships, and disregarded entities as qualified owners of pass-through entities making a PTET election
- Allows specified guaranteed payments paid to partners to be included in the definition of qualified net income subject to the PTET calculation. The amendments are retroactive to January 1, 2021
- For tax years beginning on or after January 1, 2022, requires the PTET credit to be applied against the net tax after any credits for taxes paid to other states
SB113 also lifts the suspension of net operating loss (NOL) deductions and removes the temporary $5 million limitation on allowable business tax credits. For corporations and individual taxpayers with California net business income or modified adjusted gross income in excess of $1 million, the NOL utilization was suspended for taxable years beginning on or after January 1, 2020, and before January 1, 2023. SB113 eliminates the NOL suspension and business tax credit limitation a year early, with taxable years beginning on or after January 1, 2022.
Overall, SB113 significantly expands the population of business entities eligible to make the PTET election and alleviates various concerns around the utilization of the PTE tax credits. However, SB113 did not address other key issues, such as making the PTET credit refundable, reducing the nonresident withholding requirement, satisfying the filing requirement for nonresident taxpayers whose only California-source income is from an entity making a PTET, or increasing the PTET rate to maximize the benefit to taxpayers subject to California’s tax brackets above 9.3 percent. In light of SB113, taxpayers should examine their own tax situation to determine whether a PTET election is beneficial, as non-California residents may, among other things, not benefit from a PTET if the owners’ state of residence currently disallows a credit against its tax for any California PTET.
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