In 2017, the the pass-through entity tax (PTE) was enacted in response to the Tax Cuts and Jobs Act. California has adopted elective PTE as a way to deal with the $10,000 federal cap on deducting state and local taxes. Previously, there was no limit. Because of their high state income tax rates, states such as New York and California were hit especially hard.
What Is California Pass-Through Entity Tax?
In simple terms, the pass-through entity tax allows an entity taxed as an S Corporation or partnership to make a tax payment for its partners. Then the business pays an elective tax of qualified net income to the Franchise Tax Board.
The individual partners will receive a state tax credit paid on their individual state tax returns for their pro-rata share. Since the PTE payment is an entity business deduction, the state income tax payment is deductible on the federal tax return. However, this pass-through entity tax option is only effective for tax years beginning on or after January 1, 2021, and before January 1, 2026.
Who Qualifies To Make The Election?
If an entity is taxed as a partnership or S Corporation, they qualify to make the election. They also need to have the following members, partners, or shareholders:
- Fiduciaries
- Trusts
- Individuals
- Estates
- Corporations
These entities can make the election on their annual tax return. However, once made, the election is irrevocable for the year.
In contrast, a disregarded entity that has a single owner and is not organized as a corporation, cannot qualify to make the election. This is because it is not taxed as an S corporation or partnership.
How The Tax Is Calculated
A 9.3% tax is imposed on the entity’s qualified net income. Keep in mind that this tax is not a replacement for any other tax that applies to the entity, but rather an addition.
On the upside, you can claim a personal income tax credit for your share of the tax paid. Although the credit is nonrefundable, you can carry over unused credit for up to 5 years.
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