Did you know that as a personal taxpayer, you’re limited to a $10,000 deduction for state tax payments on your federal return? Let’s put it into perspective: say you’re a California resident paying $5,000 in property taxes and $20,000 in state income tax expense. Although your total state tax spend amounts to $25,000, the federal government only allows a deduction of $10,000.
Luckily, there’s a strategy that can help- but you have to make a decision to participate by June 15 each year. California law AB150 presents an opportunity for certain business owners to circumvent this $10,000 limit. The law introduces the Pass-Through Entity Tax (PTET) election, a scheme that allows pass-through entities like partnerships, LLCs, and S corporations to bear the state income tax rather than individual members or owners.
The most compelling part? The PTET is a flat rate of 9.3%, which allows for an attractive arbitrage opportunity for high-income taxpayers. Those who fall into CA tax brackets of 10.3% and above can potentially gain by paying the 9.3% PTET tax rate instead. This effectively enables high earners to bypass the SALT cap set by the Tax Cuts and Jobs Act of 2017.
Let’s take the case of Timmy Taxpayer to illustrate this concept better.
Timmy, a California resident, is a partner in a thriving technology consulting firm. His annual income puts him in the 13.3% California state tax bracket. Given his income, let’s say he pays $80,000 in state income tax and $10,000 in property taxes annually ($90,000 combined).
Under the current law, Timmy can only deduct $10,000 on his federal return, despite having $90,000 in state taxes. However, with the PTET election, his consulting firm, as a pass-through entity, could opt to pay the 9.3% tax directly.
Assuming the firm’s California income attributed to Timmy is $800,000, the firm could elect to pay a PTET of $74,400 (9.3% of $800,000), which would be fully deductible on the firm’s federal tax return. Not only does this allow Timmy to bypass the $10,000 limitation (by a landslide!), but it also reduces his tax bill due to the arbitrage opportunity between his personal tax rate of 13.3% and the PTET rate of 9.3%.
It’s essential to remind you that the PTET election is optional and requires you to make a decision to participate by July 15 each year.
Do you think the PTET election could be beneficial for you or your business? We encourage you to reach out to your tax advisor or accountant to discuss whether this option suits your individual circumstances. Feel free to contact our expert team for guidance. We’re here to help you navigate the complexities of tax planning and seize opportunities that can better position you and your business.