The next chapter in California's fight against the Tax Cuts and Jobs Act (TCJA) began on January 5, 2021, with the introduction of California Senate Bill 104 (SB 104) in the state legislature. If passed, SB 104 would create an elective entity-level business tax for any pass-through entity (PTE) with only individual owners. This provides a work-around to the current $10,000 limitation on an individual's federal deduction for state and local taxes paid (the "SALT Cap") in effect through 2025 under the TCJA.

Essentially, an electing business would take the federal deduction for the California taxes paid, instead of the individual owners, and the individual owners' personal California taxes would be reduced for their proportional share of such taxes paid. Several other states, such as Maryland and Connecticut, have already enacted SALT Cap work-arounds. In 2019, California attempted a different work-around involving a charitable trust, but the Internal Revenue Service (IRS) opposed that plan (see our prior post here).

In a plot twist, the IRS has apparently given the green light to the entity-level tax work-around contemplated in SB 104 and adopted by other states. In Notice 2020-75, the IRS stated that it plans to issue proposed regulations clarifying that state and local taxes imposed on and paid by pass-through entities are allowed as a deduction by the entity. However, some questions remain unanswered, such as whether the entity-level tax deduction will reduce "qualified business income" for purposes of the Section 199A deduction.

For now, Californians and entities operating in California must wait for SB 104 to make its way through the legislative process. The current, initial version leaves many issues open and will likely be revised. For example, the tax rate an entity would pay on its income was left blank in the initial draft. Additionally, the current draft seems unclear as to whether general partnerships can pay the elective tax.

Most importantly, the current draft is fatally flawed by its lack of an offset provided against the PTE owners' individual California tax liability for the tax paid at the entity level. Absent such an offset, the owner is burdened with paying California twice on the same income as the cost of obtaining the generally far less valuable federal income tax deduction for the entity-level tax. The draft bill provides only for a reduction in the individual owner's gross income equal to their share of the tax paid. But in order to truly work around the SALT cap, the reduction in gross income should equal the taxable income that the taxes paid were based on; alternatively, California could provide the individual owner a state tax credit equal to the taxes paid instead of a reduction to gross income.

Last, contrary to the draft bill, other states with this form of SALT Cap work-around generally add back the amount of the entity-level tax paid to taxable income on the owner's state return, consistent with the theme that states do not allow a deduction for their own state and local taxes paid.

Two general comments merit mention with regard to any SALT Cap work-around proposal. First, potentially, the federal SALT Cap could be repealed or modified in the coming years and, accordingly, largely eliminate the benefit of these state work-arounds. Second, are the work-arounds appropriate whenever the PTE has nonresident members? For example, if a California nonresident pays tax on income flowing through a PTE doing business in California, then typically the nonresident owner can take a credit on their resident state income tax return for at least a portion of the California tax paid by the nonresident individual. But when the tax is paid at the entity level, the question arises whether the nonresident individual's home state will disallow the "other state tax credit," thereby resulting in the individual essentially paying tax on the same income to both states as the "cost" of obtaining the federal work-around. This is not of particular concern with the California legislation, but rather a consideration for any PTE considering the application of a SALT work-around entity-level tax when the PTE has both resident and nonresident owners.

We will monitor ongoing developments with the California work-around legislation and the general availability and usefulness of these work-arounds.