Understanding The California Pass-Through Entity Tax
Understanding the PTE tax and its benefits is important for those seeking to handle the complexities of state and federal tax laws effectively. This article outlines the pass-through entity (PTE) tax's purpose, mechanics, and eligibility criteria. It also highlights the PTE tax’s role in mitigating the impact of federal tax reforms on California business owners and partnerships.
Background On The Pass-Through Entity Tax
The pass-through entity (PTE) tax was created to help people deal with changes from the Tax Cuts and Jobs Act of 2017. This law put a $10,000 limit on how much state and local taxes (SALT) people could deduct when they do their federal taxes. Before this, there was no limit, making this a big change for qualified taxpayers.
States with high taxes, like California, needed to find solutions for residents who were losing out because of the SALT cap. In response, California adopted a special tax for pass-through entities, like some small businesses. This allows business owners to pay a state tax that they can then deduct on their California tax returns. It's a way to work around the federal cap and lower overall taxes.
California Pass-Through Entity Tax FAQ
How Does The Pass-Through Entity Tax Work?
In July 2021, California introduced a new option for some businesses that lets them pay a state tax differently. This option is for pass-through entities, like some small businesses and partnerships, which can now choose to pay a 9.3% tax on the income shared among their partners or members. By paying this tax, the business owners or members can get a credit for the same amount on their personal tax returns.
Who Is Eligible For A Pass-Through Entity Tax Election?
Businesses that are structured as S corporations, general partnerships, limited liability companies (LLCs), limited liability partnerships (LLPs), or limited partnerships may be able to elect this tax payment option. However, to be eligible, these entities must have owners that are individuals, trusts, estates, or entities taxed as corporations.
Restrictions to Pass-Through Entity taxes include the following:
Businesses can't have any partnerships as owners.
Businesses can't be publicly traded partnerships.
Businesses can't be part of combined reporting groups.
When these entities opt in, they agree to pay a 9.3% tax on the income allocated to each owner who agrees to have their pro rata share of income taxed. This election is made with the entity's timely filed tax return and can't be changed for that year.
The owners who agree to this setup get a tax credit for their share, which can be a big help. If the credit is more than what they owe in taxes, they can carry forward the leftover credit for up to five years.
Please Note: The 9.3% tax rate applies to the total income of each consenting owner that's subject to California's personal income tax. This means the business’s income that can be taxed by California is what’s counted for this tax.
What Are Some Other Considerations Regarding Pass-Through Entity Tax Elections?
When considering the option to pursue the pass-through entity (PTE) tax credit, several critical factors come into play that businesses must evaluate. These key points of consideration include, but are not necessarily limited to:
Non-resident shareholders: The PTE tax credit benefits only extend to income sourced within California. This distinction is crucial for entities with non-resident members, as it may affect the applicability of credits.
S corporation distributions: S corporations need to carefully manage distributions to ensure they do not endanger their status. This includes making adjustments for shareholders who do not qualify under the PTE election to maintain equity among participants.
Impact on high K-1 income: With recent changes, notably California law SB 113, the PTE tax credit can now lower the minimum tax due. This adjustment is particularly relevant for entities with high K-1 income, marking a significant shift from previous limitations.
Tax credit limitations: A cap exists on the total amount of business tax credits, including the PTE tax credit, that can be used annually. This cap, set at $5 million, restricts the extent to which credits can reduce tax liabilities.
Carryover and refundability of the credit: While the PTE tax credit is not refundable, unused portions can be carried forward for up to five years, necessitating strategic planning to maximize benefits.
Please Note: Navigating the intricacies of the PTE tax election demands a thorough understanding of the opportunities and challenges it presents. Working with knowledgeable tax planning professionals, such as financial advisors and CPAs, is essential for business owners to make informed decisions. These experts can provide the guidance needed to effectively manage the election process and optimize tax outcomes, ensuring compliance and maximizing financial benefits.
Key Dates For The Pass-Through Entity Tax
Understanding the timeline for this tax option is crucial.
For taxable years beginning January 1, 2022, up to but not including January 1, 2026: The entity is required to make a payment by June 15th of the tax year. This payment should be either 50% of the elective tax amount from the previous year or $1,000, whichever of the two amounts is higher. The rest of the elective tax due must be paid by the original tax return due date, less the amount paid by June 15th. To keep the election valid, these payments must be timely.
After January 1, 2026: The PTE tax law is only set to last until the beginning of 2026. It’s a temporary measure, but it’s one that offers significant tax planning opportunities for eligible businesses and their owners. By opting into this tax, they can potentially save on taxes while still complying with both state and federal laws.
Get Help With Your California Pass-Through Entity Tax Election
At Burton Enright Welch, we proudly operate out of California and are experts in helping business owners minimize their lifetime tax bills. Our advisors excel in managing the complexities of the pass-through entity (PTE) tax and adapting to tax law changes, such as those introduced by the Tax Cuts and Jobs Act of 2017.
We focus on developing tax strategies aligned with your long-term goals, providing personalized advice for your unique situation. Our team can work closely with CPAs, either within our network or with your existing accountant, to integrate tax planning smoothly into your overall financial strategy.
Embarking on the path to better tax planning and financial health may seem overwhelming, but you're not alone. We're committed to guiding you at every step, ensuring you leverage every tax advantage possible. Contact us to discover how we can help with your PTE tax strategy and set you up for financial success. Schedule your call today.