Since the Tax Cuts and Jobs Act of 2017 (TCJA), taxpayers have been limited in claiming the state and local tax deduction on their personal tax filings to a maximum deduction of $10,000. In late 2020, the IRS released IRS Notice 2020-75 which permitted certain taxpayers who own pass-through businesses such as partnerships or S-corporations to workaround the state and local tax limitation assuming certain state qualifications have been met. California (and at least 22 other states) has recently passed legislation allowing California taxpayers to possibly take advantage of this new provision.

In California, qualifying passthrough entities (partnership or S-corporations) may annually elect to pay an entity level state tax on income. Please note that the partner/shareholder of the entity must also elect to have their prorated portion of the entity’s income included in this election. The benefit of this election to the partners/shareholders is that the entity (partnership or S-corporation) may claim a Federal tax deduction for the state tax payments which effectively may lower the amount of Federal income the partners/shareholders will need to report. The benefit of this deduction may vary depending on whether the entity is an operating business or investment partnership. For California tax purposes, the partners/shareholders will receive a prorate credit for the state taxes that the entity elected to pay.

For the 2022 tax year, in order to qualify to make this election, the entity must make a payment of the greater of $1,000 or 50% of the elective tax paid in the prior tax year by June 15, 2022.

For 2022 qualifying entities, participation in the California PTE program requires:

  1. An initial estimated tax payment to be made by June 15, 2022.
  2. An election to participate is required to be made on an original, timely filed tax return.

Considerations for the June 15th Payment:

  1. For pass-through entities that did not participate in 2021 and are participating for the 1sttime, a $1,000 estimated payment is due.
  2. For pass-through entities that did elect to participate in the 2021 passthrough entity tax and have filed their 2021 California tax returns, the greater of $1,000 or 50% of the 2021 passthrough entity tax amount is due as a 2022 estimate.
  3. For pass-through entities that are on extension for their 2021 pass through entity tax return, the greater of $1,000 or 50% of the 2021 passthrough entity tax amount is still required to be paid as a 2022 estimate. To calculate the tax payment, estimates of the final 2021 pass-through entity tax will need to be used. This may result in an under payment if there are late adjustments to the 2021 tax return that cause an increase to the 2021 tax. Since failure to pay the required minimum amount will result in an entity being ineligible to participate in the 2022 California Pass-Through Entity (PTE) elective tax program, using a higher estimate range for the 2021 is recommended.

Other Considerations for the 2022 California Pass-Through Entity (PTE) elective tax program.

The 2nd payment is due on or before the due date of the original return regardless of extension. Cash basis entities may want to consider making the 2ndpayment before the end of the calendar year to take advantage of the deduction against federal income the PTE provides. IRS Notice 2020-75 does indicate that the Federal tax deduction for the pass-through entity can only be deducted in the year paid regardless of the entity’s accounting method.

The California passthrough entity tax is complex and, while we await final tax regulations from the IRS as well as further clarification from the FTB, there are still some remaining uncertainties. We would be happy to discuss the program and if it fits your specific situation to help minimize your 2022 taxes.

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