California makes significant changes to PTE tax, repeals 2022 NOL/Credit limits

In detail

Pass-through entity tax provisions

California enacted AB 150 on July 16, 2021, allowing eligible businesses to elect into a PTE tax as a workaround to the $10,000 limitation on the federal itemized deduction for state and local taxes, applicable for tax years beginning on or after January 1, 2021 and before January 1, 2026. AB 150’s operative PTE tax provisions included restrictions that limited the benefit of the California PTE tax. On February 9, 2022, SB 113 was enacted, incorporating legislative changes to the PTE tax provisions to better align the intended benefit of the PTE tax for qualifying taxpayers. The enacted PTE tax changes are retroactive to 2021 with the exception of the PTE tax credit ordering rules. 

Qualified entities: Qualified entities are eligible to elect into and pay the PTE tax on behalf of their qualified partners. Section 19902 of the Revenue and Taxation Code previously defined “qualified entity” as entities that (1) are taxed as a partnership or an S corporation and (2) have partners, shareholders, or members who are corporations, individuals, fiduciaries, estates, or trusts. Accordingly, entities that had a partnership as a partner were not eligible and could not elect into the PTE tax; this restriction significantly limited the population of entities that were able to elect into the PTE tax regime. The newly enacted legislation removes this limitation and allows businesses with partners that are partnerships to elect into the PTE tax. 

Observation: The allowance of pass-through entities with partnerships and/or disregarded entities as partners to elect to pay the PTE tax will significantly expand the population of businesses that were not previously eligible and may eliminate the need to restructure business operations to create an eligible entity and/or taxpayer.

Businesses that previously were ineligible may want to consider making an election for the 2021 tax year. For the 2021 tax year, the election must be made on a timely filed tax return, which includes extensions of time to file and payment must be made on or before March 15, 2022.  

For cash-basis entities and accrual-based entities that did not have a fixed and determinable liability at their year end, there may be a mismatch between the year in which the tax is deducted for federal income tax purposes and the year in which the credit is claimed on the California tax return. For example, a cash-basis entity making a 2021 tax year payment on March 15, 2022, would pass through a 2021 PTE tax credit to its electing partners and would deduct the tax payment on its 2022 federal tax return.

Qualified taxpayer:  An otherwise qualifying taxpayer (individual, estate, trust, or fiduciary) may hold their interest in an electing entity via a single member limited liability company (SMLLC) and be considered a qualified taxpayer. Previously, the California Franchise Tax Board had indicated that a SMLLC held by an individual, estate, trust, or fiduciary would not disqualify the entity from electing into the PTE tax, but the taxpayer owner would not be a qualified electing taxpayer.

Observation:  The statute provides this exception to “a limited liability company that is disregarded for federal tax purposes…owned by a taxpayer, as defined in Section 17004…”.  The explicit use of “limited liability company” in the statute may introduce uncertainty as to whether an interest held by a disregarded partnership or other type of disregarded entity that is not a SMLLC would disqualify an otherwise qualified taxpayer from electing into the PTE tax.

Guaranteed payments: Section 19900 of the Revenue and Taxation Code defines “qualified net income” of a qualified entity to mean the sum of the pro rata share or distributive share of an electing partner’s income. The California Franchise Tax Board published a frequently asked question on its website stating “Guaranteed payments are not considered part of an entity’s qualified net income because they are not part of the distributive share for purposes of the PTE elective tax,” excluding guaranteed payments from the definition of “qualified net income.” SB 113 expands the definition of “qualified net income” to specifically include guaranteed payments.

PTE credit utilization limitation: The California personal income tax law provides that tax credits, except for “specified credits”, may not reduce regular tax below tentative minimum tax. SB 113 has made the PTE tax credit a specified tax credit for tax years beginning on or after January 1, 2021.

Observation: The prior tentative minimum tax limitation significantly restricted the utilization of the PTE tax credit, effectively limiting utilization of the credit to income taxed at an effective rate greater than 7%. This limitation impacted taxpayers in the lower income tax brackets more than those in the higher tax brackets. By contrast, the stated original intent of the PTE tax regime was to “...provide tax relief to small businesses facing unprecedented economic hurdles due to COVID-19.”  

Action item: Many taxpayers intended to forego the PTE tax election due to the tentative minimum tax limitation, as it would put them in a cash negative position along with the uncertainty of utilizing all credits during the carryover period. Those taxpayers may want to reconsider the election for 2021. In light of the new law, given that PTE tax extension payments need to be made by March 15, 2022, taxpayers only have a limited window to decide what actions (if any) to take for the 2021 tax year.  

Credit utilization ordering rules: In general, with the exception of refundable credits without carryover provisions, income tax credits must be claimed before any credits for taxes paid to other states (other state tax credit or OSTC). For tax years beginning on or after January 1, 2022, SB 113 provides that the PTE tax credit is claimed after the credit for taxes paid to other states.

Observation: The change in the ordering of tax credits is important for taxpayers claiming the OSTC since the OSTC is not refundable and does not carry forward. With the limited carryover period for the PTE tax credit (five years), taxpayers should determine whether they can exhaust their PTE tax credits during the carryover period considering the OSTC utilization that now will take precedence starting in 2022 over the utilization of PTE credits. 

For tax years beginning before January 1, 2022 (2021 tax year for most), taxpayers with OSTCs should examine their own tax situation before making a PTE tax election to determine whether the PTE tax credit benefit would be reduced or eliminated by potential limited or reduced OSTC utilization, as any OSTC amounts not utilized for the year would be lost.