Looking Back – The Tax Cuts and Jobs Act (TCJA)
Prior to 2018, individuals were able to personally deduct 100% of their state and local taxes they paid as an itemized deduction on their tax returns. The Tax Cuts and Jobs Act (TCJA) limited this deduction to $10,000 total. For example, let’s say you paid a total of $25,000 in property taxes and state income taxes. Prior to TCJA, you could deduct the $25,000 but since the passing of TCJA you could only deduct $10,000 effectively causing individual taxpayers to lose a $15,000 deduction.
Introduction of The State and Local Tax (SALT)
Since December of 2017, high tax states like California have been working on legislation that would reduce the impact of the state and local tax (“SALT”) deduction limitation. Last year, the California Assembly Bill 150 (AB 150) was signed into law as California’s solution to the SALT limitation which allows certain owners of pass-through entities a way to deduct more than the current SALT deduction limitation of $10,000.
Here Comes AB 150
California’s AB 150 allows qualified pass-through entities (Partnerships, S corporations and LLCs filing as partnerships) to elect to pay and deduct a pass-through entity tax of 9.3% on qualified net income. This elective tax is a tax paid at the entity level that is deductible by the entity for federal tax purposes. When the tax is deducted at the entity level the benefit of the tax is passed on to the individual and reduces their overall federal tax liability.
Qualified entities will need to make an annual election to pay a 9.3% tax on the entities qualified net income. For tax years beginning in 2022, the elective tax is due in 2 installments. The first installment must be the greater of $1,000 or 50% of the pass-through entity tax paid in the prior year which is due by June 15th, 2022 and the remaining amount is due on or before the due date of the original return (without regard to extension). If you are a cash-basis taxpayer, you will need to pay the 2nd installment by December 31st to ensure you can take the deduction for the 2022 taxes paid by the entity.
How It Works
For example, let’s assume a S-Corporation has one owner and the entity has qualified net income of $1,000,000.
Without AB 150, the owner pays tax on $1,000,000 assuming the California tax rate of 9.3% for a total of $93,000 of tax. This tax is not deductible for Federal tax purposes (assuming they already deduct the $10,000 of property taxes), so they also pay $300,000 of Federal tax (assuming a federal tax rate of 30%). The total federal and California taxes on the $1,000,000 of qualified net income that passes through to their personal tax returns is $393,000.
With AB 150, the S-Corporation elects to pay the California taxes directly through the entity at 9.3% of the $1,000,000 of qualified net income for a total of $93,000. This tax is deductible for Federal tax purposes reducing the federal net income to $907,000, so they now only pay Federal taxes in the amount of $272,100 ($1,000,000 – $93,000 = 907,000 x 30%). The total federal and California taxes on the $1,000,000 of qualified net income that passes through to the personal tax returns is $365,100. This produces a federal tax savings of $27,900 just by electing to pay your California personal taxes through the entity on the owner’s behalf to reduce the overall federal tax liability.
Opt In Before The 2022 Deadline
In summary, AB 150 could result in large benefits to taxpayers who own pass-through entities that qualify to take this election. It is important that the election is taken by June 15th to opt in for the 2022 tax year. Please reach out to the Spinnaker Tax Team so we can evaluate the application of AB 150 to your personal tax situation.
