California Provides Path to Deduct State Income Tax for Calculating Federal TaxJuly 23, 2021 – Client Alert
In IRS Notice 2020-75, the IRS invited the states to circumvent the $10,000 limit on the deduction of state taxes by individuals, trusts, and estates for purposes of calculating federal income tax by permitting the states to implement an “elective” tax on certain pass-through entities and permitting a credit for those taxes to the owners of the entities. Thus, instead of the owners paying non-deductible state income tax, the entities can pay the elective tax as a deductible expense that passes through to the owners as a federal deduction and state tax credit. Voila! A non-deductible state income tax becomes deductible!
It is remarkable that the IRS issued such a notice, but it is not remarkable that the states are taking up the offer, including most recently California in Assembly Bill 150 signed into law on July 16. To make the new law understandable, this article omits some of the arcane details and instead uses lay person’s language. It is thus critical to consult with a tax advisor based on your particular facts before relying on this summary.
Capitalized words used in this article have the following meanings:
“AB 150” means California Assembly Bill 150, which includes the new law discussed in this article.
“Election” means an election by a Qualified Entity to pay the Elective Tax on behalf of one or more Qualified Owners.
“Elective Tax” means a tax of 9.3% on the net income allocable by a Qualified Entity to a Qualified Owner.
“Qualified Entity” means S corporations and partnerships (including LLCs with multiple owners that are treated as partnerships for tax purposes), but excludes partnerships with any partnerships as partners. A single member LLC is disregarded for tax purposes and thus cannot be Qualified Entity unless it has elected to be taxed as an S corporation.
“Qualified Owner” means owners of a Qualified Entity that are subject to the State Tax Limit, namely individuals, trusts, and estates, that have consented to the Election. Qualified Owners cannot be C corporations, S corporations, or partnerships, although S corporations and partnerships may separately be Qualified Entities. An LLC owned by one individual is disregarded for tax purpose, so the individual owner of such an LLC that is itself an owner of a Qualified Entity should be a Qualified Owner.
“State Tax Limit” means the $10,000 limit on the deduction of state taxes for purposes of calculating federal income tax.
AB 150 is effective immediately for all of 2021 and continues through 2025, when the federal State Tax Limit is set to expire.
Making the Election
In order for AB 150 to apply, a Qualified Owner must consent to the Qualified Entity making the Election to pay the Elective Tax at a 9.3% rate on the Qualified Owner’s share of net income of the Qualified Entity. The procedures for this consent are not specified, and, if the Franchise Tax Board does not address this issue before the 2021 tax filing season, the safest course is for each Qualified Owner and the Qualified Entity to both sign a written consent. It is not necessary for all (or even a majority) of the owners of a Qualified Entity to consent to the Election.
The Qualified Entity makes an irrevocable Election on an annual basis on a timely filed California tax return for each year. AB 150 does not specify who has the authority on behalf of the Qualified Entity to make the Election, and presumably whoever has authority to make other tax elections for the Qualified Entity will have the authority to make the Election. However, given that the election means that the Qualified Entity becomes liable for the Elective Tax, which is a more significant consequence than other tax elections, the best course of action is probably to amend the governing agreement of the Qualified Entity, which will require following whatever procedures are required to implement such amendment, which process often requires the consent of all the owners.
Liability for the Elective Tax
The Qualified Entity pays the Elective Tax on the sum of the allocable share of income of all Qualified Owners that have consented to the Election. Given that the Qualified Entity is liable for the Elective Tax, the non-consenting owners of the Qualified Entity will want to make sure that the economics of the Elective Tax are borne solely by the consenting Qualified Owners, either through one or both an offset of distributions to them or an indemnity from them in case the Elective Tax exceeds such distributions, as often occurs with so-called “phantom income.”
Timing of Payment of the Elective Tax
For 2021, the Elective Tax is due on or before March 15, 2022. For taxable years 2022 through 2025, the Elective Tax is due in two installments:
- The first installment is due by June 15th of the current year, and is the greater of $1,000 or 50% of the Elective Tax paid in the prior year; and
- The second installment for the remaining amount is due on or before March 15 of the subsequent year.
If payments are not made as required above, the Election is invalid, so it is critical that the Elective Tax is timely paid. Presumably, the FTB will revise current Forms 592-F and 592-A (currently applicable to report and pay withholding tax on nonresident partners) to accommodate the new Elective Tax regime.
Credit to Qualified Owner
Each Qualified Owner is allowed a credit against the Qualified Owner’s California income tax liability for the Elective Tax paid by the Qualified Entity on the Qualified Owner’s allocable share of income. If the credit exceeds the Qualified Owner’s California tax liability, the excess carries forward for up to five years, although it appears that all carryforwards may expire at the end of 2025, since AB 150 only applies through that year.
Treatment of Guaranteed Payments
Under Treasury Regulation section 1.707-1(c), “guaranteed payments” by partnerships for services or the use of capital under IRC section 707(c) are regarded as a partner's allocable share of ordinary income. It thus appears that the Election can be made with respect to guaranteed payments, in which case the Elective Tax should be withheld from the payments.
Trouble in Paradise for S Corporations
S corporations have a number of problems with AB 150, as outlined below.
Will the S Corporation be Respected?
Given the massive tax benefit of the Election, there will be a mad rush for every service provider that can afford it and is willing to risk it to form an S corporation and attempt to run their income through the S corporation. This, in turn, will put enormous pressure on the boundary of the appropriate use of “loan-out” corporations, and it can be expected that federal and state tax authorities will not respect the use of such loan-out corporations when the substance of the relationship to the payor is that of employer-employee. This is particularly true in California, where prior legislation (AB 5) treats almost all service providers as employees if they render services in the regular course of business of the payor, which has the net effect of disregarding certain loan-out corporations. There will be a mountain of tax-related litigation on this issue as executives attempt this strategy.
Requirement of Paying Reasonable Compensation
The second problem is that S corporations, unlike partnerships, are required to pay “reasonable compensation” to their shareholders, and such compensation does not qualify for the Election. Thus, there will be enormous pressure for S corporations to reduce the amount of compensation they pay their shareholders, and this will be another fertile area for litigation by tax authorities.
The 1.5% California Tax on S Corporations
The final challenge is that the net income of S corporations is subject to a 1.5% California tax, so this tax will offset somewhat the benefit of the Election, since the benefit of the Election only applies to the net income of the S corporation.
Explosion in Partnerships
Given the difficulties with S corporations mentioned above, the better path is to use partnerships, so there is likely to be an explosion in all forms of partnerships with 1% partners or even husband and wife partnerships. Form seems to prevail over substance under AB 150.