Alert

California Legislature Seeks to Offer State and Local Tax Cap Workaround

On January 05, 2021, the California State Senate introduced significant legislation in Senate Bill 104 (SB104) that, if passed, could provide a workaround for owners in pass-through entities (PTE) from the current individual annual $10,000 limitation on the deduction against federal taxable income for state and local taxes (SALT) paid. California SB104 seeks to circumvent the SALT cap deduction by allowing the PTE to elect to pay California tax on net income earned by the entity. In turn, the individual owners would then exclude from California taxable income an amount equal to the tax for which the PTE paid for such individuals, based upon their pro-rata share.

California SB104 presents a substantial opportunity for potential relief from the current annual $10,000 cap on the SALT deduction for partners, members, and shareholders in partnerships, LLCs, and S corporations. The possibility of California’s passage of SB104 is bolstered by California Governor Gavin Newsom’s January 5, 2021, proposed California recovery plan which includes “[m]itigating the SALT deduction limitation for S-corporation shareholders.”

Below, we provide background on the proposed legislation as well as key points taxpayers should know.

Background on SALT Cap

The federal tax reform changes of 2017 made several changes to the SALT deduction, notably, establishing a limit, or SALT cap, on the amounts claimed as SALT deductions for tax years 2018 through 2025. The SALT cap is currently $10,000 for single taxpayers and married couples filing jointly.

Following this enactment of the SALT cap, several states, including California, proposed or passed legislation that provided the possibility to reduce the SALT cap’s effect through various provisions. However, subsequent guidance by the IRS made it clear they would take an aggressive position against those workarounds and prevent taxpayers from relief of the SALT cap’s effects.

IRS Notice 2020-75 Opens Opportunity for States

On November 9, 2020, the IRS released guidance in Notice 2020-75 indicating that state income taxes imposed on and paid by a partnership or S corporation on its income are allowed as a deduction by the partnership or S corporation in computing its non-separately stated taxable income or loss for the year of the payment.

Unlike individuals, entities do not suffer a SALT cap so they can deduct all of the state and local taxes paid at the entity level. The IRS guidance expands this opportunity by allowing for the partnership and S corporation’s payments to not be considered in applying the SALT cap limitation for the benefit of any individual who is a partner in the partnership or shareholder in the S Corporation.

As a result, the IRS provided an opportunity for states to enact legislation to permit a SALT cap workaround. The Treasury Department and the IRS expect to propose regulations consistent with IRS Notice 2020-75. Any such forthcoming regulations should provide additional guidance for states to adopt legislation consistent with the purpose of adopting a SALT cap workaround.

Legislation SB104

California’s SB104 proposed legislation seeks to capitalize on the opportunity provided in IRS Notice 2020-75 to circumvent the SALT cap deduction by allowing the PTE to elect to pay California tax on net income earned by the entity. In turn, the individual owners would then be able to exclude from California taxable income an amount equal to the tax for which the PTE paid for such individuals, based upon their pro-rata share.

California’s proposed legislation provides that PTEs eligible for the California election are entities taxed as partnership and S Corporations, which include LLCs taxed as a partnership for federal and California income tax purposes.

By allowing the PTE to elect to pay tax on net income earned by the entity, California’s SB104 provides a mechanism for the individual owners of the PTE to exclude the income on which the PTE paid tax. As a result, this elective tax would work similar to a composite or group return, with the added benefit that the taxes paid by PTE would be reflected as deduction against income of the PTE, and the taxes paid wouldn’t be taken into account in applying SALT cap limitation to any individual partner, member, or shareholder in the PTE.

Tax Rate Unclear

It’s important to note that while SB104 would allow for the PTE to elect to pay tax, the legislation hasn’t yet set the tax rate to be utilized. It’s reasonable to presume the California legislature will adopt a tax rate consistent with California’s composite or group tax return allowed for entities taxed as partnership, currently 13.3%.

Limitations on Use of SB104

SB104 also includes some notable constraints.

1. Owner Requirement for Individuals

For the PTE to elect to pay the tax, all owners in the PTE must be individuals, but the legislation as currently written offers no comments on whether PTE ownership by certain trusts would preclude eligibility. Of note, those PTE owners eligible to make the California election include only individuals, though these can be California residents, nonresidents, or part-year residents. 

2. Binding Election

If the PTE elects to pay the tax, the election is binding on all owners, meaning individual owners can’t separately elect a different treatment from other individual owners of the same entity.

3. Election Timing

The PTE election to pay the tax must be on an original, timely filed return. The election can’t be retroactively made through an amended return.

Should the proposed legislation become law, we expect FTB will clarify these and other technical matters in subsequent regulations.

We’re Here to Help

Moss Adams is following these changes closely. If you have questions about how they may affect your business, state tax filings, or operations, please contact your Moss Adams professional.

Contact Us with Questions

Enter security code:
 Security code