California's PTE Tax Election May Require Legislative Fix
California became one of the 19 states and counting that has enacted its own pass-through entity (PTE) tax election statute as a workaround to the federal $10,000 limitation on the state tax deduction (the SALT deduction cap) when it enacted A.B. 150 on July 16, 2021. Unfortunately, that legislation currently includes a limitation on the use of the credit that significantly limits the benefit of making the election.
The Pass-Through Tax Credit and California’s Tentative Minimum Tax
Like the majority of states that have enacted PTE tax elections, California requires individual owners of PTEs making the election to include their distributive share of income from the PTE in their personal tax return, then provides the owners with a tax credit equal to their share of the state PTE tax paid by the electing entity. Unlike the other states that provide a pass-through tax credit mechanism, the California credit is non-refundable and any excess credit may be carried forward only five years.
Pursuant to Cal. Rev. & Tax. Code section 17062(a), California personal income tax equals the excess of the tentative minimum tax (TMT) for the tax year over the regular tax for the tax year. Among other items, including enactment of a new section 19900 to provide for a PTE tax election, A.B. 150 also enacted Cal. Rev. & Tax. Code section 17052.10(a), which is the PTE tax credit. Section 17052.10(a) provides that the PTE tax credit is used against the “net tax” defined in section 17039. In turn, Cal. Rev. & Tax. Code section 17039’s definition of “net tax” references only the regular California personal income tax code sections that are applicable to residents, part-year residents and nonresidents, but makes no reference to Section 17062, the TMT. As a result, it appears that without a legislative fix, the California PTE tax credit is not creditable against California TMT. Further, when the California Franchise Tax Board (FTB) updated its FAQs regarding the PTE tax election on October 1, 2021, the FTB summarily answered, as follows:
- Q: Can the PTE credit reduce the amount of tax due below the tentative minimum tax?
- A: No, the PTE tax credit does not reduce the amount of tax due below the tentative minimum tax.
Accordingly, without a legislative fix, the California PTE tax election may not mitigate the SALT deduction cap as intended. While the TMT does not apply to income, adjustments and tax preference items attributable to trades or businesses owned by a taxpayer or owned by a PTE of which the taxpayer holds an ownership interest, when the aggregate gross receipts of the trades or businesses are less than $1 million, such taxpayers are likely subject to a California tax rate less than the 9.3% rate imposed on electing PTEs. Thus, for certain taxpayers, taking the PTE election results in a higher tax rate in addition to the credit’s other disadvantages (that the credit is not refundable and has only a five-year carryforward period). High-net worth individuals owning interests in PTEs are therefore more likely candidates to make, or to encourage their PTEs to make the election. However, the exclusion of the California TMT from the PTE tax credit appears to be a significant drawback for high earners considering the election.
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