Good News for Business Owners – California Assembly Bill 150
By Rob Trammell, Principal
For those of us living in California, or other high tax states, there was a nasty section of the Tax Cuts and Jobs Act (TCJA) that has been causing some pain since 2018. That was the $10,000 limitation on the amount of state and local taxes that could be deducted for federal purposes. Even though your state income and property taxes could well exceed that amount, the maximum deduction on your federal return was limited to $10,000.
Good news – there may be some relief in sight thanks to California Assembly Bill 150. AB 150 established the Small Business Relief Act and allows for an elective pass-through entity tax. That is a mouthful, so what does it mean?
It means that if you are an owner of a flow-through entity, the entity can pay your California state tax and claim that as a deduction on its federal return as a business expense. This reduces the ordinary income reported by the entity rather than being reflected as an itemized deduction for state tax payments on your personal return. You then report the payment made by the entity as a tax credit on your California return.
Now that we get the idea, let’s discuss who is eligible and next steps.
Eligible entities
- Entities taxed as partnerships and S corporations.
- All owners must be corporations, individuals, fiduciaries, and estates or trusts
Ineligible entities
- Entities with other partnerships as owners (it is currently unclear if ownership by disregarded entities like single-member LLC’s will make the entity ineligible)
- Single-member LLC’s
- Entities required or permitted to be included in a California combined reporting group
How is it done?
- Through an annual election
- By entity owners that are California residents or nonresidents
- Election is irrevocable
- Election is made on entity’s timely filed tax return
Example
Ok, that is a lot of information, and like most tax concepts, is not inherently easy to understand. Let’s go through an example. Assume Joe is the sole owner of an S corporation that has $1,000,000 of ordinary income. If we assume his California tax rate is 12%, he pays $120,000 in California tax but can only deduct $10,000 as an itemized deduction on his federal return.
Under the new law, Joe can have his S corporation pay $93,000 of California pass-through entity tax (the tax payment is limited to 9.3% of the entity’s income). This is treated as a federal deduction so Joe reports federal income of $907,000 ($1,000,000 – $93,000) on his return and claims the $93,000 payment as a tax credit on his California return. Thus, the $93,000 is no longer subject to the limitation.
The IRS has blessed this solution which many other states either have adopted or have similar legislation pending. However, like most newly enacted changes, there are unresolved issues and the landscape can change quickly. We will keep you updated as new information becomes available as action may be required before the end of 2021. Contact us to learn how this new tax provision can benefit you.