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The California legislature has great news for some business owners: The budget act includes a mechanism that allows S corporations, partnerships, and LLCs to pay a pass-through tax equaling 9.3 percent on qualified net income.

In other words, the S-corp, partnership, or LLC can pay its owners’ California tax obligation at the rate of 9.3 percent. This means that the owner’s reportable income can be reduced by the tax the entity pays on behalf of the owner.

While that expense will not be deductible for state purposes, the owner can report a non-refundable credit against their California income tax from the amount withheld. The reduced reportable income will lower Federal income tax, which will be a net tax savings to the owner.

This is a big deal.

The budget measure, which was filed with the Secretary of State on July 16, also avoids limitations on state tax deductibility on individual or trust tax returns.

This new election applies to tax years 2021 through 2025. Qualified net income is a sum of the distributive share of income of the entities’ individual, trust, or estate owners that consent to have their share of income subject to the elective pass-through entity tax. Partnership owners of partnerships may not elect to have their taxes paid.

Taxpayers make the election on an annual basis—and can only take the pass-through option on original, timely tax filings. Only entities taxed as S corporation or partnerships are eligible to make this election, and only if the entities’ shareholder or partners are not partnerships.

The consenting pass-through entity owners can also claim a nonrefundable credit for the amount of tax paid on owners’ distributive share of income. Unused credit can be carried over for up to five years.

For the 2021 tax year, the pass-through entity tax is due on the due date of tax return without regard to the extension (due on March 15, 2022). However, for years 2022 through 2025, the electing entity has to make two payments. The first payment is due by June 15 of the taxable year. The required amount of payment is the greater of $1,000 or 50 percent of the elective tax paid for prior year. Entities that fail to make the first payment by the deadline are prohibited from paying the pass-through tax for that tax year.

The California legislature empowered the FTB to create regulations which are to implement this new law. The devil will be in the detail and, hopefully, they will fill in the blanks. In any case, this new law is a good thing.

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