Passthrough Entity Tax

TAX UPDATE FOR CALIFORNIA BUSINESS OWNERS

Elective Passthrough Entity Tax

For 2021 through 2025 taxable years, a qualified S-Corporation or Partnership that is doing business in California may elect to pay a pass-through entity tax equal to 9.3% of its qualified net income.

This change allows California pass-through entities to take a deduction for the state tax paid in advance and avoid the $10,000 State and Local Tax (SALT) limitation imposed by the Tax Cuts and Jobs Act of 2017 (TCJA). Many individuals in California are phased out of a SALT deduction due to the $10,000 limitation as the calculation considers both the real estate taxes paid during the year and the state income tax withheld on your W-2 or paid in as estimated tax payments during the year. If those two expenses combined exceed $10,000, then you are negatively impacted by the SALT limitation. The pass-through entity tax allows you to deduct some of your state income tax payments before being limited by the SALT deduction.

For example, XYZ Partnership has 2021 net income of $100,000 and is owned 100% by a single individual. The individual made $9,300 of California estimated tax payments and paid real estate taxes of $10,000 for 2021. If the partnership does not elect the pass-through entity tax, then the result is the following:

Income from XYZ Partnership: $100,000
SALT deduction $10,000 (Total paid = $19,300)

While the individual paid $19,300, they only get a deduction for $10,000 due to the SALT limitation. If the partnership elects to pay the 9.3% passthrough entity tax on the partnership net income, then the result is the following:

Income from XYZ Partnership: $90,700 ($100,000 – $9,300)
SALT deduction $10,000 (Total paid = $10,000)

This allows the individual to get the full deduction of the $19,300 paid during the year and avoid being limited by the $10,000 SALT limitation.

For 2021, the elective tax is due by March 15, 2022, however, the payment must be made by December 31, 2021, to get the deduction on the 2021 tax return.

Starting in 2022, the elective passthrough entity tax payments are due in installments: 50% on June 15 of the taxable year and 50% by the entity’s original filing date (March 15). If the taxpayer does not remit the first payment by June 15 of the taxable year, they will be prohibited from making the election to pay the pass-through entity tax on the timely filed return.

Our team is standing by to assist with your year-end tax planning needs. If you think the elective passthrough entity tax may help you, please contact our office at (858) 483-7500 or by email at inbox@yourreason.com.