In July 2021, Governor Gavin Newson signed AB 150, which includes a State and Local Tax (SALT) cap workaround. The effect of this legislation is that qualified entities can elect to pay tax to California so that the entity can take the deduction and reduce federal taxable income. As a result, the individual taxpayer enjoys a lower taxable income on Form 1040 and then settles up on a California return. Taxpayers capped at $10,000 of SALT deduction on Form 1040 Schedule A will appreciate this workaround.
For tax years 2021 through 2025, a qualified partnership, S Corporation, or LLC taxed as a partnership or S Corporation that is operating in California and filing a California tax return may make an election to pay a passthrough entity elective tax equal to 9.3% of its qualified net income.
How the AB 150 SALT CAP Workaround helps
The partner or shareholder reports the net income on the California return, which does not include that tax payment, and will also receive a California credit equal to the partners/shareholder’s allocation of the 9.3% elective entity tax paid by the entity. Since the entity took the deduction for the California tax paid, this reduces the AGI to the K-1 recipient rather than having a SALT deduction on Schedule A, which is subject to the $10,000 SALT deduction limit. Therefore, on Form 1040, the pass-through income is reduced by the amount of the tax paid by the entity.
On the California entity return, the state tax deducted on the federal return will be an addback to arrive at California K-1 income. Still, the K-1 recipient will receive a tax credit equal to their pro-rata amount of the 9.3% entity tax.
Example of AB 150 SALT Cap workaround in action
Betty Bison, LLC, is a multi-member LLC taxed as a partnership in California. The LLC has a qualified net income of $200,000. Betty has a 50% interest, and her other partner holds the remaining 50% interest. Both partners qualify and make the election; consequently, the partnership pays $23,250 (9.3% * $250,000). The partnership then reports $113,375 (($250,000 - $23,250) * 50%) of net income on each of the two federal K-1s. California returns filed by the partners will report $125,000 of net income from Betty Bison, LLC ($113,375 federal net income + $11,625 elective passthrough entity tax paid to California) and a credit of $11,625 against their individual California income tax.
About The Author
Tony Ennenga is a Senior Manager at Dark Horse CPAs specializing in Tax Strategy, Tax Planning, Fractional CFO, and Tax Resolution engagements for his high-net-worth individuals and business clients. He serves clients in the San Francisco, CA, and Billings, MT markets but services businesses nationwide. Interested in working with Tony? You can book a discovery call with him here.
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