Perspectives
Whether or not to elect into the California PTE tax regime
California’s pass-through entity tax (PET) imposes an income tax directly on the pass-through entity, as opposed to the partners, members, or shareholders. What should you consider when deciding whether or not to elect into the California PET regime?
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- PET regimes
- To elect or not to elect?
- Endnotes
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PET regimes
As of February 9, 2022, twenty-two states have enacted PET legislation.1 While many of the state PETs target similar goals, each regime is unique, and the differences between them are often stark. These differences make the implications of electing into a PET dependent on the pass-through entity’s geographic footprint, income profile, and business needs, in addition to tax classifications, residencies, and activities of each of the pass-through entity’s partners, members, or shareholders. To better understand some of the moving pieces, below we examine California’s recently enacted pass-through entity tax, including technical corrections made by the California legislature in February 2022.
Understanding California’s pass-through entity tax
California’s pass-through entity tax election is effective for tax years beginning on or after January 1, 2021, and before January 1, 2026, for qualified entities required to file a California return.2 An electing qualified entity pays the 9.3 percent CA PET. Qualified taxpayers receive a credit for their share of CA PET paid.3
To elect or not to elect?
As with many new tax regimes, the CA PET has issues that need to be analyzed and further clarified. The following are a few issues to consider and discuss with your tax adviser when considering California’s new pass-through entity tax regime.
- Nonresident issues: Among state PET regimes, California is unique in that the state does not require all owners to be included. Factors such as a qualified taxpayer’s state of residence and the fact that the CA PET may be carried over, whereas unused other state tax credit is lost, should be taken into consideration when analyzing the pros and cons of consenting into the CA PET.
- Other state tax credits: California specifies the order that credits need to be utilized.4 Senate Bill 113 changed the usage order of credits for January 1, 2022, and before January 1, 2026, thus reducing the risk of a qualified taxpayer losing their other state tax credit; however, modeling specific results is recommended to make sure the taxpayer can anticipate their ability to use the credit carryover within the five-year period.
- Nonresident withholding: Qualified entities electing into the CA PET will still be responsible for remitting withholding on behalf of their nonresident partners where applicable. Nonresident owners that consent to inclusion in the CA PET should consider applying for a nonresident withholding waiver exemption to reduce double remittance.5
- Tax credits limited to $5 million: In June 2020, Assembly Bill 85 (“AB85”) was signed into law in California, putting a $5 million limit on the use of business tax credits that may reduce a taxpayer’s California income tax liability. This limitation is applicable through tax year 20216 and applies to the sum of all business credits available in a particular year, including the CA PET credit.
- CA PET credit is non-refundable but may be carried over for up to five years: To the extent a taxpayer cannot utilize the entire amount of CA PET credit in a given year, they may carry the excess credit forward for five years after which point it will expire. Modeling at the individual owner level is helpful in determining whether a qualified taxpayer’s particular facts run the risk of having expired CA PET credit.
- Guaranteed payments are includable in the CA PET tax base: Per the technical corrections made as part of Senate Bill 113 (2022) guaranteed payments are included in the CA PET tax base.7
- S corporation election: S corporations that are considering making the CA PET election could potentially violate their S election if they change their distributions to fix the economics caused by some of their shareholders not consenting to inclusion and/or the consenting shareholders are composed of California residents and nonresidents. The AICPA has asked the IRS Chief Council’s Office of Passthroughs to issue guidance on the possible second class of stock issue.8
- Qualified taxpayer excludes disregarded entities: While having a disregarded entity as a partner or member does not disqualify a pass-through from qualified entity status and making the CA PET election, a business entity that is disregarded is not eligible to receive CA PET credit. Entities that are disregarded under California Revenue and Taxation Code 23038 are considered disregarded for purposes of eligible taxpayer status; however,9 the FTB has confirmed that grantor trusts could be qualified taxpayers.
- Tiered partnerships: With the passage of Senate Bill 113 (2022), taxpayers with tiered partnership structures that want to participate in California’s pass-through elective tax regime are no longer excluded from participating.10 However, an upper tier partnership’s share of income may not be included in the qualified entity tax base and the upper tier partnership owner will not receive any CA PET credit.
- General partnerships: The Franchise Tax Board has stated that general partnerships are eligible to make the CA PET election so long as they otherwise meet the definition of a qualified entity set forth in California Revenue and Taxation Code Section 19902.11
- Election timing and payment considerations: For tax year 2021, the election must be made on an original, timely filed return including extensions.12 As the CA PET election will be made after calendar year 2021, this raises questions around the deductibility of the CA PET expense for tax year 2021. These issues and questions should be discussed with a tax adviser when considering the timing of the CA PET payments and the deductibility of the expense for both a cash basis and an accrual basis taxpayer.
While California’s PET regime appears straightforward at first glance, the details are complicated and require a deeper analysis. The analysis is heavily weighted at the owner level, and pass-through entities should encourage their owners to consult with individual tax advisers to determine whether to consent to inclusion in California’s PET regime.
Endnotes
1 These include Alabama, Arizona, Arkansas, California, Colorado, Connecticut, Georgia, Idaho, Illinois, Louisiana, Maryland, Massachusetts, Michigan, Minnesota, New Jersey, New York, North Carolina, Oklahoma, Oregon, Rhode Island, South Carolina, and Wisconsin. As of the same date, Ohio and Pennsylvania have proposed PET legislation. This is in addition to jurisdictions that already impose entity-level taxes, such as the District of Columbia, New Hampshire, New York City, Tennessee, and Texas.
2 See CAL REV. & TAX. CODE §§ 17052.10(a) - (b), 19900, 19902. Qualified entity generally includes partnerships, limited liability companies treated as partnerships, and S corporations.
3 See REV. & TAX. §17052.10(a).
4 See REV. & TAX. § 17039.
5 See Franchise Tax Board Form 588.
6 See Senate Bill 113 (2022).
7 See Senate Bill 113 (2022).
8 See AICPA Offers Comments on Future Proposed SALT Regs, 2021 TAX NOTES TODAY (Oct. 26, 2021).
9 Id.
10 See Senate Bill 113 (2022).
11 Ibid.
12 See REV. & TAX. § 19001(d).
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