In IRS Notice 2020-75, the IRS urged states to circumvent the $10,000 limit on the deduction of state taxes by individuals, trusts, and estates for purposes of calculating federal tax on income by allowing states to implement an “elective” tax on certain flow-through entities and allowing a credit for these taxes to the owners of the entities. So instead of owners paying non-deductible state income tax, entities can pay the optional tax as a deductible expense that is passed through to owners as a federal deduction and property tax credit. the state. So ! A non-deductible state income tax becomes deductible!
It is remarkable that the IRS issued such a notice, but it is not remarkable that states are accepting the offer, including most recently California in Assembly Bill 150 enacted on July 16. To make the new law understandable, this article omits some of the esoteric details and instead uses the language of a layman. It is therefore essential to consult a tax advisor based on your particular facts before relying on this summary.
Capitalized words used in this article have the following meanings:
“AB 150” stands for California Assembly Bill 150, which includes the new law discussed in this article.
“Election” means an election by a Qualified Entity to pay Elective Tax on behalf of one or more Qualified Owners.
“Optional tax” means a tax of 9.3% on the net income attributable by a Qualified Entity to a Qualified Owner.
“FTB” means the California Franchise Tax Board.
“Qualified Entity” means S corporations and partnerships (including LLCs with multiple owners that are treated as partnerships for tax purposes). A single member LLC is not considered for tax purposes and therefore cannot be a qualifying entity unless it has elected to be taxed as an S corporation.
“Qualifying Owner” means owners of a Qualifying Entity who are subject to the state tax limit, namely individuals, trusts and estates, who have consented to the election. Qualifying owners cannot be C corporations, S corporations, or partnerships, although S corporations and partnerships can be separately qualified entities. An LLC owned by an individual is disregarded for tax purposes, so the individual owner of such an LLC who themselves owns a qualifying entity is a qualifying owner.
“State Tax Limit” means the $10,000 limit on the deduction of state taxes for federal income tax purposes.
AB 150 is effective immediately for all of 2021 and continues through 2025, when the federal state tax limit is due to expire.
make the election
For AB 150 to apply, a qualified owner must consent to the qualified entity electing to pay optional tax at a rate of 9.3% on the qualified owner’s share of the net income of the qualified entity. qualified entity. The procedures for this consent are not spelled out and, if the Franchise Tax Board does not address this issue prior to the 2021 tax filing season, the safest course is for each Qualified Owner and Qualified Entity to sign written consent. It is not necessary that all (or even the majority) of the owners of a qualified entity consent to the election.
The qualified entity makes an irrevocable election on an annual basis on a timely filed California tax return for each year. AB 150 does not specify who has the authority on behalf of the Qualified Entity to make the Election, and presumably anyone who has the authority to make other tax elections for the Qualified Entity will have the authority to make the Election. However, since the election means that the qualified entity becomes liable for the optional tax, which is a greater consequence than other tax elections, the best solution is probably to modify the agreement governing the qualified entity. , which will require following whatever procedures are required to implement such a change, which often requires the consent of all owners.
Liability for optional tax
The qualified entity pays the optional tax on the sum of the attributable share of the income of all qualified owners who have consented to the election. Since the qualified entity is liable for the optional tax, the non-consenting owners of the qualified entity will want to ensure that the optional tax is borne only by the willing qualified owners, either by one or both a set-off of distributions to them or compensation from them in the event that the optional tax exceeds those distributions, as often happens with so-called “phantom income”.
Timing of optional fee payment
For 2021, the optional tax is due no later than March 15, 2022. For tax years 2022 to 2025, the optional tax is due in two installments:
- The first payment is due before June 15and of the current year, and is the greater of $1,000 or 50% of the optional tax paid the previous year; and
- The second installment of the remaining amount is due no later than March 15 of the following year.
If payments are not made as required above, the election is invalid, so it is essential that the optional tax is paid in a timely manner. However, even if part of the optional tax can be paid after the end of the year, if the qualified entity uses the cash method of accounting, it will have to pay the tax before the end of the year in order to go through the current year’s deduction for qualified homeowners. Qualified Entities must use the Transferring Entity’s Optional Fee Remittance Voucher (FTB 3893) to remit the fee to the FTB.
Credit to qualified owner
Each qualifying owner is entitled to a credit against the qualifying owner’s California income tax for optional tax paid by the qualifying entity on the qualifying owner’s share of attributable income. If the credit exceeds the qualifying homeowner’s California tax liability, the excess is carried forward for up to five years, although it appears that all carryovers could expire at the end of 2025, since AB 150 only applies until this year.
Guaranteed payment processing
Section 707-1(c) of the Treasury Regulations states that “secured payments” by partnerships for services or use of capital under Section 707(c) of the IRC are considered as the attributable share of a partner’s ordinary income, and an amendment to the original bill is now expressly includes the optional tax on guaranteed payments.
Not limited by minimum tax
Under an amendment to the original bill, the optional tax credit is not subject to the minimum tax limit that applies to other tax credits.
Trouble in heaven for S corporations
S corporations have a number of issues with AB 150 as shown below.
Will the S Corporation be respected?
Given the enormous tax advantage of the election, there will be a mad rush for every service provider who can afford it and is willing to risk it to form an S corporation and attempt to funnel their income through the intermediary of the S corporation. This, in turn, will put enormous pressure on the limit of the appropriate use of “loan” corporations, and it can be expected that federal and state tax authorities will not respect the use of these loan companies when the substance of the relationship with the payer is that of employer-employee. This is especially true in California, where previous legislation (AB 5) treats almost all service providers as employees if they perform services in the ordinary course of the payer’s business, which has the net effect of not holding account of some loan companies. There will be a mountain of tax litigation over this issue as executives attempt this strategy.
Duty to pay reasonable compensation
The second problem is that S corporations, unlike partnerships, are required to pay “reasonable compensation” to their shareholders, and such compensation is not eligible for election. Thus, there will be enormous pressure on S corporations to reduce the amount of compensation they pay to their shareholders, and this will be another fertile area for litigation by the tax authorities.
California’s 1.5% tax on S corporations
The final challenge is that S corporation net income is subject to a 1.5% California tax, so this tax will somewhat offset the election benefit, since the election benefit only applies to the net income of company S.
Prohibition of two classes of shares
S corporations are not allowed to have two classes of stock, so if there are multiple shareholders and the S corporation does not elect for all (e.g. non-California shareholders), economic differences and distributions would likely cause the S corporation to violate this requirement, blowing its S election.
Explosion of partnerships
Given the difficulties with the S corporations mentioned above, the best path is to use partnerships, so it is likely that there will be an explosion of all forms of partnerships with 1% partners or even partnerships husband and wife. Form seems to take precedence over content under AB 150.