Tax legislation (S.B. 113) signed by Governor Gavin Newsom makes several important tax changes, including expanding the availability and benefit of the state's pass-through entity (PTE) tax credit, with most provisions taking effect during the 2021 tax year; reinstating the net operating loss (NOL) deduction without limit for tax years beginning on or after January 1, 2022; and eliminating the $5 million tax credit limitation for tax years beginning on or after January 1, 2022.
These changes bring welcome planning opportunities for tax years 2021 and beyond.
Changes to PTE Tax Credit
Unless otherwise stated, the following changes to California's PTE tax credit take effect beginning with the 2021 tax year:
- Including guaranteed payments in qualified net income (previously, guaranteed payments were not included in the measure of tax subject to the PTE elective tax),
- Expanding eligibility for the credit to include partnerships with partnership partners, but specifying that upper-tier partnerships must make their own election (i.e., the upper-tier partnership cannot opt in to the PTE election of the lower-tier partnership),
- Adding single member LLCs (SMLLCs) to the definition of a qualified taxpayer that may opt in to the election,
- Allowing the PTE tax credit to reduce the regular tax below the tentative minimum tax,
- Permitting, for tax years beginning after January 1, 2022, the PTE elective tax to be applied against net tax after credits for taxes paid to other states (OSTC), and
- While not part of S.B. 113, the Franchise Tax Board clarified in its Form 541 Schedule K-1 Instructions, Beneficiary's Share of Income, Deductions, Credits, etc. that the PTE tax credit may pass through to an estate or trust beneficiary.
Planning Insights for PTE Elective Tax Changes
Sole Proprietorships or Certain SMLLC Owners Should Consider PTE Election Planning
Business owners that hold a partnership interest through a SMLLC should consider the PTE election. Business owners that operate as sole proprietorships or in a SMLLC form should consider reorganizing into a pass-through entity to take advantage of the PTE elective tax benefit.
Impact of Applying PTE Tax Credit Before the Other State Tax Credit (OSTC) in 2021
For 2021, the PTE tax credit is applied first and the OSTC second. This may be good for taxpayers subject to the $5 million credit limitation still in effect for 2021. However, it may create an odd limitation because the PTE tax credit has a five-year carryover provision but OSTC does not. A partner that derives most or all of their income from a multistate partnership is the most likely to be affected.
Taxpayers with OSTC should compute the PTE elective tax benefit considering the reordering of credits.
Elimination of NOL Suspension and $5 Million Tax Credit Limitation
Reinstating NOL Deductions
The NOL deduction is reinstated under the legislation without limit for tax years beginning on or after January 1, 2022. Previously, the NOL deduction was suspended for taxpayers with California taxable income above $1 million for taxable years 2020 through 2022.
Removing the $5 million Tax Credit Limitation
The measure eliminates the $5 million tax credit limitation for tax years beginning on or after January 1, 2022. Previously, a $5 million limit on business tax credits applied to both individuals and corporations for tax years 2020 through 2022.
Planning Insight for End of Tax Credit Limitation
California allows taxpayers to make state-only accounting method elections. Taxpayers who may be facing attribute limitations in 2021 may consider method changes to manage the timing of taxable income.
The Takeaway
The enacted legislation expands the availability and benefits of the PTE tax credit, reinstates the NOL deduction and eliminates the $5 million limitation on business tax credits. These changes bring welcome tax planning opportunities starting in the 2021 and/or 2022 tax years. Andersen can model the benefit of making the PTE election and other planning to take advantage of these favorable tax changes. Contact an Andersen advisor to learn how these changes impact you.