Since the Tax Cuts and Jobs Act (TCJA) passed in 2017, taxpayers can only claim the state and local tax deduction on their Federal personal tax filings to a maximum deduction of $10,000. The passthrough entity tax may allow certain taxpayers to offset more of their income with a state tax deduction for Federal tax purposes.
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 may effectively 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 prorated credit for the state taxes that the entity elected to pay.
Who can make an election?
In California, qualifying passthrough entities (partnership or S-corporations) may annually elect to pay an entity level state tax on income (passthrough entity tax). 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 following taxpayers are qualified to make this election:
Individuals, fiduciaries, estates, and trusts subject to California personal income tax
Disregarded single member LLCs that are owned by individuals, fiduciaries, estates, or trusts subject to California income tax
How is the election made?
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 15th and must also make an election on their original, timely filed tax return.
Additional Considerations
Currently, the rules to elect into the California passthrough entity tax ($1,000 or 50% of elective tax paid in the prior year by June 15th) are extremely inflexible. As such, we strongly recommend being conservative in ensuring that you pay the sufficient amount by the June 15th deadline to ensure that your entity is eligible for the California passthrough entity tax. For example, if your 2023 tax return is currently extended (so your 2023 passthrough entity tax is not yet finalized), you will want to use a conservative approach to calculating 50% of this tax for your 2024 passthrough entity payment.
The second passthrough entity 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 second payment before the end of the calendar year to take advantage of the deduction against federal income the PTE provides. IRS Notice 2020-75 indicates that the Federal tax deduction for the passthrough entity can only be deducted in the year paid regardless of the entity’s accounting method.
Realize can help
The California passthrough entity tax is complex and, while we continue to await final tax regulations from the IRS, there are still some remaining uncertainties. Please note that at least 35 other states have enacted some version of the passthrough entity level tax to allow their taxpayers to take advantage of these provisions. We would be happy to discuss the program and if it fits your specific situation to help minimize your taxes.
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