Owners of Pass-Through Entities Stand to Benefit
In 2017, the Tax Cuts and Jobs Act placed a limit of $10,000 on the amount of state and local taxes individuals can deduct against their income. Prior to that, the total amount paid in real estate taxes, personal property taxes, and income taxes to states and localities were fully deductible as an itemized deduction. For many taxpayers, this was a substantial reduction, particularly owners of pass-through entities who pay the tax on all business profits on their individual income tax return.
Since then, more than fifteen states have enacted new entity-level taxes or created elections to work around the limitation including New York, Wisconsin, Minnesota, and Arizona. At least six more states have pending legislation addressing the issue.
California is the most recent state to add a pass-through entity-level tax. The law signed by Governor Newsom last month allows S-Corporations, partnerships, and LLCs taxed as partnerships to pay tax on the electing owner’s share of income. The taxes paid are deductible by the entity for federal tax purposes, effectively bypassing the state tax deduction limitation. The law is in effect for tax years 2021-26, but is automatically repealed if the federal limitation is repealed.
The tax is a flat 9.3% on California source income. Each owner can choose whether to be included in the election or not, and consent of all owners is not required for the entity to make the election. The electing owners receive a credit against their personal California tax liability for the amount paid by the entity. If the full credit cannot be utilized in that tax year, the excess can be carried forward up to five years.
To make this election for 2021, the entity must pay the associated tax by the due date of the tax return without regard to extensions. For a calendar year filer that date is March 15, 2022. Beginning with tax year 2022 the elective tax must be paid in two installments. The first payment is the greater of $1,000 or 50% of the elective tax paid in the prior year, due June 15th of the current year. The second installment is due on the tax return due date. Once made, the election is irrevocable for that tax year.
Given that many pass-through entity owners pay more than $10,000 in total state and local taxes, this workaround has the potential to provide significant savings. If you have any questions about your personal tax situation, Creative Planning is here to guide you through tax law changes.