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Editorial 9 MIN READ

California AB 150, at the mid-session mark

A pending pass-through entity tax that, if it clears the Senate, lets California owners route a 9.3% state tax through the entity and deduct it federally

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 6 sections
  1. What IRS Notice 2020-75 actually said
  2. Where AB 150 actually is
  3. The math for a concrete California owner
  4. The parts that are still soft
  5. What a California-tied reader should do in June 2021
  6. Sources

ssembly Bill 150 is the vehicle California is using to answer IRS Notice 2020-75, and as of June 1 it is still in the Assembly. If the bill clears in something close to its current form, a California S-corp or partnership will be able to elect an entity-level tax at 9.3% of qualified net income, deduct that tax federally at the entity, and pass a matching credit through to the owners' California personal returns.

That is the whole pitch: move the state income tax inside the partnership or S-corp, where it is not a Schedule A itemized deduction subject to the $10,000 SALT cap, and collect a state credit on the other side so the owner does not pay twice. Six or seven states have already done this. California is in the late-to-the-party cohort, and the specifics of the bill still matter because the Senate has not taken it up.

What IRS Notice 2020-75 actually said

The federal permission slip arrived on November 9, 2020, when Treasury and the IRS released Notice 2020-75. The notice does two things. It announces Treasury's intent to issue proposed regulations, and it describes what those regulations will say so that taxpayers can rely on the guidance now for any specified income tax payment made on or after November 9, 2020.

The operative rule is in section 3.02 of the notice. A partnership or S-corporation that pays a state or local income tax imposed on the entity itself may deduct that payment in computing its non-separately stated taxable income or loss for the year of payment. The deduction is taken at the entity, before the K-1 hits the owner. It is not subject to the SALT cap in section 164(b)(6), because that cap applies to individuals itemizing, not to the entity computing its business income.

The notice is careful about the predicate. The tax has to be imposed on the entity. A tax the owner pays and is reimbursed for does not qualify. A composite or withholding tax computed by reference to the owner's distributive share and paid on the owner's behalf does not qualify either; those were already structured that way and Treasury declined to let them piggyback on the new regime. The tax has to be a real entity-level liability, set by state law, and paid by the entity.

That is the constraint every state is drafting around. Connecticut had the first statute in 2018, before the notice, and structured it as a mandatory entity tax (which is a different problem). Wisconsin, Oklahoma, Louisiana, New Jersey, Rhode Island, and Maryland came in behind with elective regimes built specifically to meet the Notice 2020-75 test. California is pattern-matching on those.

Where AB 150 actually is

Assembly Bill 150, introduced January 8, 2021 by Assembly Members Cooper and Bloom, started life as a spot bill and was substantively amended in April to carry the Small Business Relief Act language. It is a budget trailer bill in posture, which is why its final form will depend on budget conference and why the mid-session shape may not be the enacted shape.

As written in the May amendments, the bill adds new R&TC § 17052.10 (the owner-side credit), new R&TC §§ 19900 through 19906 (the entity-level elective tax), and related conforming language. The elective tax would be 9.3% of "qualified net income," defined as the sum of each consenting qualified taxpayer's pro rata or distributive share of income subject to California tax. Qualified entities are partnerships and S-corporations whose owners are individuals, estates, trusts, or certain fiduciaries. Publicly traded partnerships are out. Partnerships with any partner that is itself a partnership are out, which is a meaningful restriction for tiered structures common in real estate and private funds.

Election is annual, made on a timely filed original return, and irrevocable for the year. Every consenting owner has to actively consent; a non-consenting owner is not swept in, and the entity's qualified net income is computed only from consenting owners' shares. The owner-side credit under § 17052.10 equals the 9.3% tax paid on the owner's share, usable against California personal income tax with a carryforward for excess credit.

The bill as drafted covers taxable years beginning on or after January 1, 2021, which is the relevant piece for readers thinking about 2021 planning. It also contains a sunset the analogous trailers in other states have used: the regime would terminate with federal repeal of the SALT cap or a date certain, whichever comes first. The specific sunset date in the May draft is subject to conference and should be checked against the enrolled text if and when the bill moves.

As of today the bill has cleared Assembly Revenue and Taxation and is awaiting Assembly Appropriations. The Senate has not taken it up. The Department of Finance has not issued a formal position in the public analyses so far. A floor vote before the summer recess is plausible; enactment with the budget is the working assumption of the practitioners watching this closely.

The math for a concrete California owner

Take a two-partner California partnership with $1,000,000 of California qualified net income, split 50/50 between two individual partners, both in the top federal bracket (37%) and the top California bracket (13.3%). Both partners consent.

Without AB 150, each partner picks up $500,000 of K-1 income. California tax on the $500,000 is $66,500 at 13.3% (ignoring mental-health surtax mechanics and brackets, which round to the same place for this arithmetic). That $66,500 is an itemized state tax deduction capped at $10,000 on the partner's federal Schedule A. Federal income tax on $500,000 of K-1 income is $185,000 at the marginal 37% rate. Total out of pocket per partner on the California layer: $66,500. Federal benefit of the state tax: effectively zero beyond the first $10,000 of combined SALT.

Under AB 150 as drafted, the partnership elects and pays 9.3% on $1,000,000 of qualified net income, which is $93,000. That $93,000 is a deduction against the partnership's ordinary income, reducing non-separately stated income from $1,000,000 to $907,000. Each partner's K-1 ordinary share falls from $500,000 to $453,500. Federal tax on $453,500 at 37% is $167,795, a federal savings of $17,205 per partner, or $34,410 for the partnership.

On the California side, each partner's § 17052.10 credit is $46,500 (half of the $93,000 paid). California personal income tax on each partner's $500,000 share is still $66,500, reduced by the $46,500 credit to $20,000. California revenue is unchanged in the first order: it collected $93,000 at the entity and will collect $40,000 from the partners, for $133,000 total. Without the election it would have collected $133,000 directly from the partners. The state is neutral; the federal fisc is the party paying for this.

The partnership-level benefit of roughly $34,000 on $1,000,000 of income is the number to hold in your head. The 9.3% rate applied to the full qualified net income, times 37% at the federal level, equals about 3.4 cents on the dollar. That is the ceiling. It is less if partners are not in the top bracket, less if the entity has non-California apportionment issues, and less if a non-consenting owner dilutes the electing base.

The parts that are still soft

Four pieces of the bill are worth watching before you plan around it.

The first is the treatment of guaranteed payments. The notice does not address them directly, and the state drafters have handled them differently across jurisdictions. The May version of AB 150 counts distributive-share income but is not crisp on guaranteed payments to partners. Practitioners should expect a technical clarification either in the enrolled bill or in early Franchise Tax Board guidance.

The second is the interaction with the existing $800 minimum annual tax on LLCs under R&TC § 17941. AB 150's elective tax is layered on top of the $800 floor; it does not replace it. An LLC that elects partnership treatment federally and opts into the AB 150 regime would pay the $800 under § 17941, the 9.3% AB 150 tax on qualified net income, plus the LLC gross-receipts fee under § 17942 where applicable. Owners then collect the § 17052.10 credit on their personal returns. The order of operations and the mechanical interaction with the gross-receipts fee are areas where the FTB will need to publish a form and instructions before the first return season.

The third is nonresident owners. A California partnership with out-of-state partners can elect, and consenting nonresidents get the § 17052.10 credit against California nonresident tax. What a nonresident owner's own home state does with the AB 150 payment is a separate question: some states will treat the California entity-level tax as a creditable tax for resident-credit purposes, and some will not. This is a meaningful variable for, say, a New York resident who is a partner in a California operating entity.

The fourth is the consent mechanic and the carried-interest problem. A fund structured as a California partnership with sponsor and LP interests has every reason to want the election, but one non-consenting LP takes that LP's share out of qualified net income for the year. In a widely held partnership with a mix of taxable and tax-exempt or foreign partners, the consenting base may be smaller than the entity's total income, which dilutes the per-partner benefit and complicates allocations. Fund sponsors should read the consent language carefully when the enrolled version lands.

What a California-tied reader should do in June 2021

Track the bill. If you are operating an S-corp or partnership with California-sourced income and California-resident owners in the top bracket, AB 150 is the single largest piece of 2021 federal-state planning on the table. A reasonable posture right now is to model both scenarios (election and non-election) with the May draft's 9.3% rate and decide your intended election before Q3 estimated payments. The Franchise Tax Board will publish a form when the bill is enrolled; the first estimated payment deadline under the analogous New York and New Jersey regimes was handled by guidance rather than form, and California is likely to do the same.

For entities that are already considering structural changes for reasons unrelated to AB 150, the bill does not argue for a formation move by itself. California residents who own through a California partnership will benefit without changing domicile. California residents owning through a Delaware LLC taxed as a partnership with California operations will also benefit, because the entity files a California return and can elect. The question is whether the entity qualifies (no partnership partners, no PTPs), not where the certificate is filed.

For a broader view of how the state PTET patchwork compares, our state PTET workarounds: map and math walks through the six jurisdictions that enacted before California.

One last note on timing. The working assumption that AB 150 moves with the budget means the window between enactment and the first tax year it covers is short. If the bill is signed in July or August and applies to 2021, calendar-year entities will have only a few months to decide and prepay. The states that have already done this saw a scramble in the first electing year, with FTB-analog agencies issuing informal guidance faster than usual. Expect the same in Sacramento.

Sources

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