Can Pass-Through Entity Tax Help Your Business?

In the United States, there is a double tax for California business owners, in the form of California income taxes with high marginal rates and federal restrictions on the ability to deduct state and local taxes (SALT). The Pass-Through Entity Elective Tax (PTE tax) is a potential method for minimizing federal taxable income for owners of S corporations, partnerships, and other qualifying LLCs in California.

Under AB 150, this election enables eligible pass-through entities to claim state income tax as a business, and avoids the individual owner being held liable for it. If properly implemented, it can offer substantial federal tax savings. Look for tax experts who provide IRS tax levy help.

What about the SALT Cap Problem?

Many individual tax filers have a cap of $10,000 on their SALT. This limit can easily be surpassed by residents of California with significant income, property taxes, and business profits.

The cap could also limit the amount of California income taxes that can be deducted on a federal income tax return for the owner of a business who is subject to California’s high tax rates.

To solve this issue, the PTE tax election moves qualifying state tax payments to the entity level. Under Federal rules, eligible state income taxes paid by a partnership or S corporation may be deducted as an income item on the partnership or S corporation’s tax return, as opposed to the individual S corporation owner or partnership owner paying those taxes as a personal itemized deduction. Hire an expert (like a federal tax attorney) and get help.

How California’s PTE Tax Works

The general elective PTE tax is levied on qualifying partnerships and S corporations, such as certain LLCs treated as partnerships or S corporations, in California.

The tax rate is 9.3% on the qualified net income from consenting eligible owners. The entity’s share of the tax is paid to the California Franchise Tax Board (FTB), and participating owners are eligible to receive a corresponding credit on their personal income taxes in California (subject to certain rules).

The strategy is as follows:

• Entity-level payment: A payment is made to the business for the qualifying California PTE tax.
• Federal deduction: The allowable payment usually lowers the amount that the pass-through income is reported on the owners’ federal tax returns.
• California credit: If an owner participates, they take the applicable California credit on the owner’s returns.
• The potential federal savings: If a pass-through income is lower, then a lower amount of federal taxable income can help offset the effect of the federal cap on the individual SALT deduction.

In not all situations, the deduction will directly lower the owner’s adjusted gross income by a set amount. It can have a significant effect on the entity’s federal reporting, the owner’s situation, and tax law. Get experts (like Beverly Hills, California tax attorneys) if you don’t have any prior experience in taxation.

Payment and Key Deadlines:

The PTE election is NOT automatic. Failure to make a necessary payment or comply with a requirement can result in the loss of the desired benefit.

Prior to voting, use this checklist:

• Confirm eligibility – confirm that the entity is eligible and who the owners are whose income can be included.
• Pay the first installment: California normally has an elective tax payment deadline of June 15 of the taxable year. Generally, the required amount is the larger of $1,000 or 50% of the prior year PTE tax, with applicable rules in place.
• Pay any balance due: The balance usually comes due at the original filing date of the entity (and not at an extended date).
• Ensure the entity makes the election on a timely filed original California return for the applicable taxable year: Make the annual election.
• Make sure eligible owner credits get to eligible owners and understand any credit limitations.

March 15 is a common filing deadline for calendar-year entities to file Form 1065 or Form 1120-S with the federal government; it is not the general deadline for calendar-year entities to elect tax status with the California PTE. The federal deadline for returns is not the same as California’s deadline for payments and the election.

Here are a Few Tips for Avoiding Expensive Mistakes:

1. Save money for June 15th in a timely manner.
2. Coordinate with your CPA prior to filing the entity return.
3. Check for ownership transfers and eligibility of owners prior to calculating the tax.
4. Match up entity payments to California credits and federal deductions.
5. Review the plan every year as tax laws and situations may change.

Used appropriately, the PTE tax in California can offset the federal burden of the SALT cap on qualified business owners, but only if it’s used correctly. But speak to a competent tax advisor about whether the election makes economic sense for your company.