California’s new rule to avoid the $10,000 cap on state tax deductions

 In Tax News

The 2017 Tax Cuts and Jobs Act capped the individual itemized deduction of state and local taxes to $10,000, which significantly decreased one of the biggest deductions for most Californians.  This is because in California between the high-income tax rate and real estate taxes many taxpayers paid well over $10,000. Governor Newsom recently signed California Assembly Bill 150 into law which offers a work around for the $10,000 federal cap on state and local tax deductions for individuals.  The newly passed bill will allow pass-through entity owners to deduct more than the $10,000 in state and local tax.

The rule works by allowing pass-through entities to elect to be taxed at the entity level on their net income for taxable years beginning on or after January 1, 2021, and before January 1, 2026. This allows owners of pass-through entities to take deductions of state income taxes paid beyond the cap of $10,000 because the income taxes will be paid at the entity level instead of the individual partner level where the deduction is capped.  Since the pass-through income will still be on the individual return, there will be a credit for taxes paid by the entity.  The elective tax is calculated at 9.3% on each qualified owner’s pro rata share or distributive share of net income of the pass-through entity.

There are still many details to work out as it is not quite clear how it will be reported on the tax return.  Also, there are several restrictions and limitations as to who can use the law.  However, it does present some obvious planning opportunities.  First, it will likely be helpful for California residents with existing pass-through entities, if the analysis is done to compare the 9.3% rate and credit to the standard taxes.  Next, as it stands now the new law does not apply for California residents with single-member LLCs/disregarded entities or sole proprietorship/Schedule C businesses. Therefore, there may be planning done for these taxpayers to consider turning the business into a qualifying pass-through entity.

As the reporting and logistics are finalized, we will provide more information on the application, planning and implementation.

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