California and Arizona Join States With SALT Cap Workarounds

In response to the federal state and local tax (SALT) deduction $10,000 cap enacted as part of the Tax Cuts and Jobs Act (TCJA), California Governor Gavin Newsom signed budget legislation (A.B. 150) that includes a pass-through entity workaround for tax years beginning on or after January 1, 2021. The measure creates an elective tax, which allows certain pass-through entities to annually elect to pay on behalf of their owners and allows an equal credit to those owners that consent to have the tax paid on their behalf.  Arizona’s Governor Doug Ducey signed a similar legislative measure (H.B. 2838) effective for tax years beginning January 1, 2022.

California

The time period during which the election is available corresponds with the applicability of the federal SALT deduction cap under Internal Revenue Code Sec. 164(b)(6), which was enacted under the 2017 Tax Cuts and Jobs Act (TCJA) and applies to taxable years 2018 through 2025. If the federal SALT deduction cap is repealed before it is set to expire under the TCJA, then the California elective tax would be inoperative for the corresponding taxable years.

The election is available to a partnership, limited liability company treated as a partnership or S corporation for every taxable year that they are a qualified entity. A qualified entity is a pass-through entity that:

• Is not disregarded for federal purposes,
• Does not have any owners that are partnerships,
• Is not part of a combined reporting group for corporation tax purposes, and
• Is not publicly traded.

The election to pay the tax is irrevocable and can only be made on an original, timely filed return for the taxable year in a form and manner as prescribed by the California Franchise Tax Board.

The elective tax rate of 9.3% applies to the sum of pro-rata shares or distributive shares of income of any of its partners, shareholders or members upon their consent. A partner, shareholder or member that does not consent does not prevent the entity from making an election to pay the elective tax.

A non-refundable credit is allowed to each partner, shareholder or member that consented to have their pro-rata or distributive share of income included in the calculation of the elective tax. The amount of the credit is equal to the elective tax paid on the partner, shareholder or member’s behalf for each taxable year that the qualified entity elects to pay the tax and the partner, shareholder or member consents to have the tax paid on their behalf. Unused credits can be carried forward for up to five years.

For taxable years beginning on or after January 1, 2021 and before January 1, 2022, the elective tax must be paid by the original due date of the return. For taxable years beginning on or after January 1, 2022 and before January 1, 2026 any qualified entity that elects to pay the elective tax must:

• On or before June 15th of the taxable year of the election, pay an amount at least as much as the greater of:

• 50% of the elective tax paid the prior taxable year; or
• $1,000.

• On or before the original due date of the return, the qualified entity is required to file and pay, without regard to any extension of time for filing the return for the taxable year, an amount equal to the amount of elective tax, less the payment made on or before June 15th of the taxable year.

For each taxable year beginning on or after January 1, 2022, and before January 1, 2026, if no payment is made as required, the qualified entity may not make the election to pay the elective tax.

Arizona

For tax years beginning January 1, 2022, a partnership or S corporation may elect to pay a 4.5% tax on its taxable income that is attributable to the entity’s resident partners or shareholders “and the portion of its taxable income derived from sources within [Arizona] that is attributable to its nonresident partners or shareholders.” Eligible partners and shareholders, which are individuals, estates and trusts that do not opt out of the election or waive their right to opt out, are allowed a personal state income tax credit equal to the portion of the tax paid on their share of pass-through income.

The election must be made on or before the due date or extended due date of the business’s return. If the partnership or S corporation does not pay the amount owed as a result of the election, the state tax authority may collect the amount from the partners or shareholders based on the proportionate share of income that is attributable to each partner or shareholder.

A partnership or S corporation that intends to make the election must provide notice to each eligible partner or shareholder regarding the right to opt out of the election. Eligible partners or shareholders have 60 days to respond to the notice otherwise they are included in the election. 

The Takeaway

California and Arizona have both passed legislation creating an elective pass-through entity tax to serve as a workaround for taxpayers affected by the federal SALT deduction $10,000 cap that was enacted as part of the TCJA. The measures add California and Arizona to the growing list of states that have recently enacted similar workaround provisions. The enactment of the measures will come as welcome news to California and Arizona taxpayers, because the Biden administration’s FY 2022 budget and infrastructure bills do not include a repeal of the federal SALT cap deduction. To understand how California or Arizona’s SALT cap workaround impacts your business, contact an Andersen advisor.