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Topic: Tax Compliance

Prepare for These Key Operational Challenges with Your U.S. Expansion

This article is part of an ongoing series, “Navigating the Complexities of Setting Up a Business in the USA”. View all the articles in the series here.

Key Takeaways:

  • Plan for U.S. employee benefits — they differ greatly from other countries and require employer management.
  • Choose the right U.S. location to improve coordination, tax benefits, and operational efficiency.
  • Secure proper insurance and banking solutions to avoid common challenges faced by foreign businesses in the U.S.

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Expanding into the United States is a strategic move that offers your business significant opportunities for growth — particularly as the U.S. continues to attract substantial foreign direct investment (FDI). Recent data highlights the U.S. as a leading destination for global businesses, but companies entering the U.S. market still face a host of operational challenges. Careful planning and a thorough understanding of the regulatory and logistical landscape are crucial for a smooth transition.

This article delves into the operational considerations your business must address when expanding into the U.S. — focusing on employee benefits, coordination, supply chain management, insurance, and banking.

Importance of Operational Planning

Effective operational planning is the cornerstone of a successful expansion into the U.S. market, especially as FDI continues to drive economic growth in the region. This planning involves not only understanding the regulatory environment but also anticipating challenges related to employee management, supply chains, insurance, and financial operations. Inadequate planning can result in significant delays, increased costs, and potential legal issues — which can be particularly detrimental in a competitive market increasingly influenced by global investment.

Employee Benefits and Regulations

When expanding to the U.S., your company must navigate a complex landscape of employee benefits and regulations — which differ from those in your home country. In many sectors that are seeing increased FDI, such as manufacturing and technology, understanding and managing these benefits is critical to attracting and retaining top talent in the competitive U.S. job market.

  • Differences in Employee Benefits Between the U.S. and Other Countries: In many countries, such as those in the European Union, employee benefits like health insurance and retirement plans are often managed or mandated by the government. However, in the U.S., these benefits are typically the responsibility of the employer. This shift can be surprising for foreign companies, requiring a thorough understanding of U.S. labor laws and regulations.
  • Health Insurance, Retirement Plans, and Other Benefits: U.S. employers are generally expected to provide health insurance as a standard benefit — with medical, dental, and vision benefits often requiring contracts with separate insurance carriers. Employers must typically cover 50% of insurance costs (though minimum coverage varies by state). Many companies also offer retirement plans such as 401(k)s. Navigating the selection and administration of these benefits can be challenging, particularly for small- or medium-sized enterprises. You may need to consult with benefits professionals to stay compliant with U.S. regulations and remain competitive in the job market.
MKT000343-Essential-U.S.-Expansion-Tips

Logistics and Supply Chain Management

Managing U.S. operations efficiently requires careful consideration of location, coordination, and infrastructure needs. Strategic decisions about operational setup can have a notable impact on your overall business success.

  • Choosing the Right Location for Operations: The U.S. is a vast country with significant regional differences in cost, labor availability, and infrastructure. Selecting the right location for your operations can affect everything from shipping costs to employee satisfaction. For instance, companies focused on manufacturing might prefer regions with lower labor costs and favorable tax treatments; those in distribution might prioritize proximity to major logistics hubs.
  • Shipping and Inventory Management: Efficient shipping and inventory management are essential to support product flow and meet customer expectations. Foreign companies in the U.S. often rely on third-party providers to manage these aspects — especially if they lack a physical presence. However, this can create tax obligations in multiple states, as having inventory in a state may trigger state and local tax filing requirements.
  • Obtaining the Necessary Insurance Coverage: Foreign companies often discover their existing insurance policies do not cover their U.S. operations. It’s crucial to secure the appropriate insurance coverage — either through global policies that extend to the U.S. or by obtaining new policies tailored to U.S. risks. Your coverage needs may include general liability, property, product liability, workers’ compensation, and employment practices liability depending on the nature of the business.
  • Challenges in Opening Bank Accounts: Opening a bank account in the U.S. can be a complex process for foreign-owned businesses. Some banks may be hesitant to provide accounts or offer credit facilities to companies without a U.S. presence or substantial collateral. This can limit access to credit and other financial services, making it essential to plan financial operations carefully.

Setting Your Business Up for U.S. Success

Expanding into the U.S. market requires careful consideration of various operational factors — from employee benefits and logistics to insurance and banking. As the U.S. continues to attract substantial foreign direct investment, it is critical to understand and address these challenges to be competitive and position your business for successful growth. By planning accordingly, you can capitalize on the opportunities presented by this dynamic market.

Ready to launch your U.S. expansion? Reach out to our team today to learn how we can help support your operational planning efforts.

Setting up a business in the U.S. requires thorough planning and an understanding of various regulatory and operational challenges. In this series, we will delve into specific aspects of this process, providing guidance and practical tips. Our next articles will explore the complexities of navigating states and local taxes.

IRS Releases Dual Consolidated Loss Proposed Regulations

Key Takeaways:

  • The Treasury and IRS released new proposed regulations affecting how dual consolidated losses (DCLs) are calculated and their interaction with the Pillar Two global tax regime.
  • A new set of rules for disregarded payment losses (DPLs) has been introduced — these apply to disregarded payments deductible in foreign countries, but not included in U.S. taxable income.
  • The proposed regulations expand the definition of a separate unit and address how foreign tax rules (under Pillar Two) may trigger foreign use restrictions on DCLs.

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The Department of the Treasury and the IRS on August 6 released proposed regulations on the dual consolidated loss (DCL) rules and their interaction with the Pillar Two global taxing regime. The proposed regulations also make several changes to how DCLs are calculated and introduce a new disregarded payment loss rule.  

DCL Rules

The DCL rules apply to ordinary losses of a dual resident corporation (DRC) or a separate unit. A DRC is either (1) a domestic corporation that is subject to an income tax of a foreign country on its worldwide income or taxed as a resident under the law of that country; or (2) a foreign insurance company that elects to be taxed as a domestic corporation under Internal Revenue Code Section 953(d) and is a member of an affiliated group, even if not subject to tax in the foreign country. A separate unit for purposes of the DCL rules is a foreign branch or hybrid entity that is owned by a domestic corporation. S corporations are not subject to the DCL rules, and domestic corporations will be treated as indirectly owning a separate unit that is owned by a partnership or grantor trust.

Under Section 1503(d), a DCL of a DRC or separate unit generally cannot be used to offset U.S. taxable income of a domestic affiliate (no “domestic use”). This means that the DCL may be used only for U.S. federal income tax purposes against the income of the DRC or separate unit that incurred the DCL.

Some exceptions apply to the domestic use prohibition; for example, a U.S. taxpayer may file a domestic use election and agreement (DUE) certifying that there has not been and will not be any foreign use of the DCL. Foreign use is defined making a portion of the DCL available under a foreign country’s income tax laws to reduce the income of another entity (one that is classified as a foreign corporation for U.S. income tax purposes).

DCLs and Interaction with Pillar Two

The proposed regulations address the coordination between foreign use under the DCL rules and Pillar Two, including expanding the definition of a separate unit to include certain hybrid entities subject to an income inclusion regime (IIR) and foreign branches subject to a qualified domestic minimum top-up tax (QDMTT) or an IIR. More specifically, the proposed rules provide that an income tax for purposes of the DCL rules may include a tax that is a minimum tax computed based on financial accounting principles, such as an IIR or QDMTT. Subject to an exception under the duplicate loss arrangement rules when a double deduction is denied, foreign use could occur if a deduction or loss included in a DCL were used to calculate net GloBE income for an IIR or QDMTT or, alternatively, used to qualify for the transitional CbCR safe harbor. The result of a foreign use would be that no DUE would be permitted to be made to allow for the DCL to be used in the U.S. The proposed rules provide no guidance on the undertaxed profit rules (UTPR).

The proposed regulations also address the concept of “mirror legislation.” The mirror legislation rule under the current DCL rules essentially provides that if the foreign country has its own DCL-type rule that “mirrors” the U.S. rule and that foreign country’s DCL-type rule applies to the loss at issue, then for purposes of the U.S. DCL rules, a foreign use of the DCL will be deemed to occur. The proposed regulations clarify that foreign law, including the GloBE rules, that deny deductions due to the duplicate loss arrangement rules, does not constitute mirror legislation as long as the taxpayer is allowed a choice between domestic or foreign use.

To address legacy DCLs, the proposed regulations provide a transition rule that, subject to an anti-abuse rule, extends the relief given in Notice 2023-80 by treating DCLs incurred in tax years beginning before August 6, 2024, as legacy DCLs and allowing the DCL rules to apply without regard to Pillar Two taxes.

Inclusions Due to Stock Ownership

Under the current DCL rules, U.S. inclusions arising from a separate unit’s ownership in a foreign corporation (such as Subpart F or GILTI) are treated as income and attributable to that separate unit for purposes of determining the income or DCL of that separate unit. This rule also applies to other types of income, such as dividends (including section 1248) and gains from the sale of stock. Under the DCL proposed regulations, with limited exceptions, these types of income (as well as any deductions or losses, such as section 245A dividends received deductions (DRD), attributable to these income items) would be excluded for purposes of calculating a DRC’s or separate unit’s income or DCL.

New Disregarded Payment Loss Rules

The proposed regulations introduce a new set of disregarded payment loss (DPL) rules, which operate independently of the DCL rules. To address certain deduction/non-inclusion outcomes, the DPL rules would apply to some disregarded payments (interest, royalties, and structured payments) that are deductible in a foreign country but are not included in U.S. taxable income because the payments are disregarded.

The DPL rules would require a consenting domestic owner of a disregarded payment entity to include in U.S. taxable income the amount of the DPL of the disregarded payment entity, subject to certain calculation requirements, if one of the following triggering events occur within 60 months: (1) a foreign use of the disregarded payment loss; or (2) failure to comply with certification requirements during the 60-month certification period. A disregarded payment entity is generally a disregarded entity, DRC, or foreign branch.

Since no express statutory authority exists for the new DPL rules, under the proposed regulations, Treasury would implement the DPL rules in coordination with the entity classification election rules under Treas. Reg. §301.7701-3(c), which means that when a specified eligible entity either elects to be disregarded for U.S. tax purposes or defaults to a disregarded entity under the general rules of Treas. Reg. §301.7701-3(b), the domestic owner would be deemed to consent to the new DPL rules. A specified eligible entity is an eligible entity (whether foreign or domestic) that is a foreign tax resident or is owned by a domestic corporation that has a foreign branch. This deemed consent rule would also apply in a situation where a domestic corporation directly or indirectly acquires an interest in a preexisting disregarded entity, as well as a domestic corporation that owns an interest in a disregarded entity by reason of a conversion from a partnership.

The DPL consent rules would apply to new entity classification elections filed on or after the date the proposed DCL rules are finalized and existing entities starting 12 months after the date the proposed regulations are finalized, which would allow taxpayers to restructure their operations before the DPL rules enter into effect.

Intercompany Transactions

The Section 1502 consolidated return regulations provide rules for taking into account certain items of income, gain, deduction, and loss of members from intercompany transactions, essentially treating consolidated group members as separate entities for some purposes and single entities for other purposes. The purpose of the regulations is to provide rules to clearly reflect the taxable income (and tax liability) of the group as a whole by preventing intercompany transactions from creating, accelerating, avoiding, or deferring consolidated taxable income (or consolidated tax liability).

The proposed regulations modify the existing regulations and generally shift application of the regulations to separate-entity treatment. More specifically, if a member of a consolidated group is a DRC or a U.S. member that owns a separate unit, the proposed regulations state that despite Section 1503(d) requiring certain treatment of the member’s tax items, the counterparty consolidated group member’s income or gain on the intercompany transaction will not be deferred. For example, if one member has intercompany loan interest expense that the DCL rules prevent from being deducted, the counterparty member’s interest income would still be included in income.

Additionally, under the proposed regulations, the Section 1503(d) member has special status in applying the DCL rules, which means that if a Section 1503(d) member’s intercompany (or corresponding) loss would otherwise be taken into account in the current year, and if the DCL rules apply to limit the use of that loss (preventing it from being currently deductible), the intercompany transaction regulations would not redetermine that loss as not being subject to the limitation under Section 1503(d). A Section 1503(d) member is an affiliated DRC or an affiliated domestic owner acting through a separate unit.

Books and Records

Under Treas. Reg. Section 1.1503(d)-5, a separate unit’s income or DCL calculation is based generally on items reflected on the separate unit’s books and records as adjusted to conform to U.S. federal income tax principles. As a result, certain transactions, such as transactions between the separate unit and its U.S. owner, are disregarded for purposes of calculating a separate unit’s income or DCL. The proposed regulations clarify that items that are not (and will not be) on the books and records of the separate unit are not included in the separate unit’s income or DCL calculation. This clarification was provided, according to the Treasury, to address positions taxpayers have taken that allocate income on the books and records of the U.S. owner to the separate unit, although those items are not on the books and records of the separate unit.

Applicability

The proposed regulations would generally apply to tax years ending on or after August 6, 2024, except for the intercompany transaction regulations, which would apply to tax years for which the original U.S. income tax return is due without extensions after the date the final DCL regulations are published in the Federal Register. This means that if the final regulations are published by April 15, 2025, they would apply to calendar year 2024. Deemed consent under the DPL rules would apply to tax years ending on or after August 6, 2025.

Once the proposed regulations are finalized, taxpayers can choose to apply them retroactively to open tax years, subject to some consistency requirements.

Insights 

The DCL proposed regulations are lengthy and complex and include significant changes that taxpayers should consider now, since many of the changes will apply retroactively to calendar year 2024 once the proposed regulations are finalized.

Taxpayers affected by the proposed regulations should consider the impact these rules may have on their DRCs or separate units, especially since the transitional Pillar Two relief is expected to end soon for many calendar-year and fiscal-year taxpayers.

Taxpayers may need to make adjustments to their DCL calculations going forward to take into account the new rules regarding removing items from the DCL calculation that are not on the separate unit’s books and records and U.S. inclusions, among others. The removal of these items could have a significant effect by unintentionally creating a DCL or increasing the amount of any existing DCL, among other possible upshots.

How MGO Can Help

If the Treasury and the IRS finalize these proposed regulations and you have a multinational company, you may lose the ability to take a U.S. deduction for losses incurred by foreign hybrid entities and foreign branches. If you are affected by the interaction of Pillar Two and the new proposed DCL rules, MGO’s team of experienced international tax advisors can discuss the potential of restructuring to minimize any negative tax consequences. We can also mockup OECD Pillar Two modeling and assist with planning for the overall minimization of your worldwide taxation with income or direct taxes. Our compliance services can help you with your foreign compliance calendars too. Trust us as we dive into the details and limit your global tax rate and overall exposure.

Written by Michael Masciangelo and Tiffany Ippolito. Copyright © 2024 BDO USA, P.C. All rights reserved. www.bdo.com

Update: How the Latest Ruling on Farhy v. Commissioner Could Affect Your Penalty Assessments

Executive Summary

  • In April 2023, the U.S. Tax Court made news when it ruled in favor of businessman Alon Farhy, who challenged the Internal Revenue Service (IRS)’s authority to assess penalties for the failure to file IRS Form 5471.
  • IRS Form 5471 is the Information Return of U.S. Persons With Respect to Certain Foreign Corporations.
  • In May 2024, the U.S. Court of Appeals for the D.C Circuit reversed the Tax Court’s initial ruling — underscoring the significance of context in assessing penalties for international information returns.

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UPDATE (May 2024):

Recent developments in the Farhy v. Commissioner case have captured significant attention in the tax and legal sectors. On May 3, 2024, the U.S. Court of Appeals reversed the Tax Court’s initial decision, highlighting the importance of statutory context in penalty assessments for international information returns. This ruling emphasizes the need for a closer examination of statutory language, altering perspectives on penalty applicability for non-compliance.

The implications of this case extend to taxpayers and practitioners, as detailed in analyses by MGO (see below). The decision underscores the need for meticulous compliance practices and adept navigation of the complexities of U.S. international tax law, along with a deep understanding of judicial interpretations of tax regulations.

MGO’s professionals are well-positioned to assist clients in navigating the complexities arising from the recent Farhy v. Commissioner decision. With a comprehensive understanding of the changing landscape in penalty assessments for international information returns, we provide guidance to help companies adapt to new judicial interpretations and maintain compliance with evolving tax regulations.

ORIGINAL ARTICLE (published June 8, 2023):

On April 3, 2023, the U.S. Tax Court came to a decision in the case Farhy v. Commissioner, ruling that the Internal Revenue Service (IRS) does not have the statutory authority to assess penalties for the failure to file IRS Form 5471, or the Information Return of U.S. Persons With Respect to Certain Foreign Corporations, against taxpayers. It also ruled that the IRS cannot administratively collect such penalties via levy.  

Now that the IRS doesn’t have the authority to assess certain foreign information return penalties according to the court, affected taxpayers may want to file protective refund claims, even if the case goes to appeals — especially given the short statute of limitations of two years for claiming refunds. 

Our Tax Controversy team breaks down the Farhy case, as well as what it may mean for your international filings — and the future of the IRS’s penalty collections.  

The IRS Case Against Farhy

Alon Farhy owned 100% of a Belize corporation from 2003 until 2010, as well as 100% of another Belize corporation from 2005 until 2010. He admitted he participated in an illegal scheme to reduce his income tax and gained immunity from prosecution. However, throughout the time of his ownership of these two companies, he was required to file IRS Forms 5471 for both — but he didn’t.  

The IRS then mailed him a notice in February 2016, alerting him of his failure to file. He still didn’t file, and in November 2018, he assessed $10,000 per failure to file, per year — plus a continuation penalty of $50,000 for each year he failed to file. The IRS determined his failures to file were deliberate, and so the penalties were met with the appropriate approval within the IRS.  

Farhy didn’t dispute he didn’t file. He also didn’t deny he failed to pay. Instead, he challenged the IRS’s legal authority to assess IRC section 6038 penalties.  

The Tax Court’s Initial Ruling

The U.S. Tax Court then held that Congress authorized the assessment for a variety of penalties — namely, those found in subchapter B of chapter 68 of subtitle F — but not for those penalties under IRC sections 6038(b)(1) and (2), which apply to Form 5471. Because these penalties were not assessable, the court decided the IRS was prohibited from proceeding with collection, and the only way the IRS can pursue collection of the taxpayer’s penalties was by 28 U.S.C. Sec. 2461(a) — which allows recovery of any penalty by civil court action.  

How This Decision Affects Your International Penalty Assessments 

This case holds that the IRS may not assess penalties under IRC section 6038(b), or failure to file IRS Form 5471. The case’s ruling doesn’t mean you don’t have an obligation to file IRS Form 5471 — or any other required form.  

Ultimately, this decision is expected to have a broad reach and will affect most IRS Form 5471 filers, namely category 1, 4, and 5 filers (but not category 2 and 3 filers, who are subject to penalties under IRC section 6679).  

However, the case’s impact could permeate even deeper. For years, some practitioners have spoken out against the IRS’s systemic assessment of international information return (IIR) penalties after a return is filed late, making it impossible for taxpayers to avoid deficiency procedures. The court’s decision now reveals how a taxpayer can be protected by the judicial branch when something is deemed unfair. Farhy took a stand, challenged the system, and won — opening the door for potential challenges in the future.  

It’s uncertain as to whether the IRS will appeal the court’s decision. But it seems as though the stakes are too high for the IRS not to appeal. While we don’t know what will happen, a former IRS official has stated he expects that, for cases currently pending review by IRS Appeals, Farhy will not be viewed as controlling law yet.  

The impact of the ruling is clear and will most likely impact many taxpayers who are contesting — or who have already paid — IRC 6038 penalties. It may also affect other civil penalties where Congress has not prescribed the method of assessment in the future. 

How You Should Respond to the Court’s Decision 

You should move quickly to take advantage of the court’s decision, as there is a two-year statute of limitations from the time a tax is paid to make a protective claim for a refund. It’s likely this legislation wouldn’t affect refund claims since that would be governed by the law that existed when the penalties were assessed. Note that per IRC section 6665(a)(2), there is no distinction between payments of tax, addition to tax, penalties, or interest — so all items are treated as tax.  

If you’ve previously paid the $10,000 penalty, it’s important to file your protective claim now, unless you’ve entered into an agreement with the IRS to extend the statute of limitations, which can occur during an examination. Requesting a refund won’t ever hurt, but some practitioners believe the IRS may try to keep any penalty money it collected, even if the assessment is invalid — because, in its eyes, the claim may not be. Just know, you can file your protective claim for a refund, but may not get it (at least not any time soon).   

The Farhy decision could likewise be applied to other US IRS forms, such as 5472, 8865, 8938, 926, 8858, 8854. Some argue the Farhy decision may also be applied to IRS Form 3520.

How MGO Can Help

Only time will tell if the court’s decision will open the government up to additional criticisms for other penalty assessments. If you have paid your penalties and are wondering what your current options are, MGO’s experienced International Tax team can help you determine if you’re eligible to file a refund claim.  

Contact us to learn more.

Tax Deadlines for California Storm Victims Extended

The IRS and the Franchise Tax Board (FTB) have granted California taxpayers affected by winter storms who reside or have a principal place of business in a county where a federal disaster declaration was made more time to file tax returns and to make tax payments. Taxpayers not in a covered disaster area, but whose records necessary to meet a deadline are in one, also qualify for relief.  

The tax relief postpones tax filing and payment deadlines occurring between January 8, 2023, and May 15, 2023, to a new due date of October 15, 2023. 

Some of the filings and payments postponed include:  

  • Individual income tax returns due on April 18 
  • Business tax returns normally due on March 15 and April 18 
  • 2022 contributions to IRAs and health savings accounts 
  • Quarterly estimated tax payments normally due January 17 and April 18 
  • Quarterly payroll and excise tax returns normally due on January 31 and April 30 

The current list of counties that qualify for this relief can be found here. 

If you qualify for this postponement, you generally do not need to contact the IRS or FTB to obtain relief. Relief is automatically granted for affected taxpayers who have an address of record located in one of the designated counties. However, if you still receive a late filing or late payment notice and the notice shows the original or extended filing, payment, or deposit due date falling within the postponement period, you should call the number on the notice to have the penalty abated.  

If you have questions or need assistance, contact MGO’s experienced State and Local Tax team. 

California Taxpayers to Benefit from Expanded SALT-CAP Workaround, Corporate Breaks

On February 9, 2022, Governor Gavin Newsom signed SB 113, enacting several taxpayer-friendly updates for 2022. Specifically, the state estimates $6.1 billion in savings to taxpayers due to increases in the amount of potential Pass-through Entity Elective Tax (PEET) credits and who can claim those credits; the removal of the suspension on NOLs and R&D credits for taxpayers for the 2022 tax year; retroactive conformity to certain federal relief provisions for tax year 2020; and increased film industry tax credits.

Specifically, under SB 113:

  • Businesses will be able to fully utilize NOLs and R&D credits for the tax year 2022.
  • There will be expanded eligibility and application of California’s Pass-through Entity Elective Tax (PEET) through several new provisions:
    • Qualified net income now includes guaranteed payments.
    • MGO Insight: This will significantly increase the value of the PEET for owners/operators of pass-through service providers.
    • Individual taxpayers can apply the PEET state credit against tentative minimum tax.
      • MGO Insight: By removing the 7% tentative minimum tax threshold, more of the PEET credit can be used in a given year, resulting in less carryovers and less concerns about electing into the PEET in consecutive years.
    • Passthrough entities with owners that are partnerships are now eligible to make the PEET election.
    • SMLLCs that are pass-through entity owners can now claim the PEET credit.
    • MGO Insight: By removing the limitation on partnership owners and SMLLCs, more pass-through businesses will be able to benefit from the PEET including lower-tier partnerships.
    • New credit usage ordering rules increase the benefit for taxpayers that claim the Other State Tax (OST) Credit.
      • MGO Insight: OST credits are now specifically utilized before PEET credits, which should significantly reduce credit leakage for taxpayers with income in multiple states. (Prior to this, there was ambiguity on the ordering of credits and concerns that certain OST credits would not be able to be fully utilized.)
    • The law also includes some beneficial retroactive relief:
      • California will fully conform to the federal treatment of Restaurant Revitalization grants, retroactive to the 2020 tax year, and partially conform to the federal exclusion of Shuttered Venue Operator grants, retroactive to the 2020 tax year.
      • Producers of qualified motion pictures benefit from increased flexibility to use sales & use tax credits against income taxes and sales & use tax; the prohibition period for this benefit has been shortened to only the 2020 and 2021 tax years. In addition, certain producers will have the ability to obtain an immediate refund for the 2021 tax year on sales & use tax in excess of the $5 million cap.

In addition to the tax benefits signed into law by SB 113, Gov. Newsom also signed SB 114, which creates COVID leave rules for 2022 that should benefit California workers:

  • Employers with more than 25 employees will be required to provide up to 80 hours of COVID-19-related paid supplemental sick and family leave for the period January 1, 2022 (retroactive) through September 30, 2022. No additional tax benefits or credits have been provided in relation to this additional requirement.

With higher-than-anticipated tax revenues during the COVID pandemic, California improved the availability of various tax benefits, resulting in significant potential tax savings for California taxpayers in 2022 and later tax years that should help boost the state’s economic recovery.

California’s Workaround to the Federal Cap on State Tax Deductions

On July 16, 2021, California joined a growing number of states that have enacted workarounds to the $10,000 limitation on the federal deduction for state and local taxes (SALT). California’s approach is to permit eligible pass-through entities to annually elect to pay a special tax (at a 9.3% flat rate) on the income allocable to certain participating owners of those entities (the “PTE Tax”) and then to claim the related tax payments as a business deduction. The result is that participating owners receive a potentially larger deduction for state taxes on their federal tax returns and a tax credit equal to their share of PTE Tax paid on their California state tax returns.

California’s workaround is in effect for the 2021 tax year and will continue to be available through the 2025 tax year (although it could expire earlier if the federal $10,000 limitation is repealed by Congress prior to its current sunset date of January 1, 2026).

The state tax credit, which is nonrefundable, can be carried over for five years. Nonresidents and part-year residents do not have to prorate the credit to account for their non-California income.

How to elect

California’s workaround is available for partnerships (including those structured as LLCs) and S corporations that only have individuals, trusts, estates, and/or corporations as owners. Publicly traded partnerships, partnerships owned by other partnerships, members of a combined reporting group, and disregarded entities do not qualify. (Disregarded Single-Member LLCs are not eligible to make the election, but will not make the entity ineligible if they are an owner of an otherwise eligible PTE).

Not all the owners of the pass-through entity need to consent to the election. Those that do not consent are not included in the calculation of the PTE Tax. To take advantage of the workaround, the pass-through entity needs to make the election annually on its state tax return. In addition, payments towards the PTE Tax need to be made by specified due dates.

• For the 2021 tax year, 100% of the PTE Tax needs to be paid by the due date for the pass-through entity’s state tax return without extensions – March 15, 2022.

• In later years, the PTE tax needs to be paid in two installments: the first installment is due by June 15 of the tax year for which the election is being made, and the second installment is due by the due date for the pass-through entity’s state tax return for that tax year without extensions (i.e., the following March 15). The minimum amount for the first installment is $1,000.

What to consider

The biggest benefit to the owners of a pass-through entity is the ability to claim a federal tax deduction for their share of the pass-through entity’s state income tax paid to California, but there is another potential benefit. In future years (starting with the 2022 tax year) PTE Tax payments may create some “float” for the owners in terms of the timing and amount of their individual estimated tax payments:

  • Individuals in California need to pay 70% of their estimated tax liability through quarterly payments on April 15 and June 15, while the PTE Tax only requires that one installment of 50% of the total tax be paid in by June 15.
  • Individuals in California need to pay the remaining 30% of their estimated tax liability by January 15 of the following year (i.e., the 4th quarter payment), while the PTE Tax only requires the remaining 50% be paid in by March 15.

However, despite these benefits, other factors should be considered before making the election:

  • If the pass-through entity provides most of the income for an owner and that owner’s top California tax rate is less than or equal to 9.3%, the state tax credit cannot be used in full before it expires. On the other hand, since the election is made annually, you could avoid accruing too much carryover by opting not to elect in a following year.
  • It’s unclear how California’s workaround will interact with pass-through entity tax regimes enacted by other states, especially their associated state tax credits. California provides credits against most other states’ taxes, but guidance has not been provided to indicate that it will afford the same treatment to other state PTE Taxes paid. Multi-state operators may not be able to reduce California taxable income by the amounts of other states’ similar taxes.
  • The 9.3% flat rate may not be sufficient to cover the full tax liability for higher income owners.
  • The PTE tax credit does not reduce the amount of tax due below California’s Tentative Minimum Tax (TMT), and thus may not be as beneficial for taxpayers subject to the TMT.
  • There are considerations pertaining to cash management, since the pass-through entity would be paying the PTE Tax, not the owners.
  • Non-resident withholding (7% for individuals) is not offset by the withholding requirements for the PTE Election. Non-resident taxpayers making the election would therefore be required to pay in tax at 16.3% among the quarterly and bi-annual installments, then claim a refund up to the amount of the 7% withholding. But because the 9.3% PTE Tax is non-refundable, to the extent that withholding exceeds tax due, it would need to be claimed in a later year.

How we can help

This PTE Election is a little complicated, but it is worth the effort to explore. MGO’s state and local tax professionals can advise you on the numerous pass-through entity tax regimes being passed by states to counter the federal limitation on deducting state taxes. Our cumulative experience as SALT specialists can help you determine if you are able to benefit from pass-through entity taxes and how to appropriately use them. Reach out to our team of experienced practitioners for your state and local tax needs.

Forging A Path Forward: CARES Act Loan and Tax Benefit Guidance

As the coronavirus (COVID-19) pandemic continues to have widespread economic impacts, small businesses, nonprofits, and similar organizations have been hit hard.

To help combat the economic fallout from the pandemic, the federal government has introduced sweeping legislation to provide emergency relief via loan and grant programs and tax breaks, credits and other incentives.

Sources of relief include:

Millions of dollars of emergency relief is now available to qualifying organizations, some of which is eligible for 100% forgiveness. Unfortunately application processes are complex and time-sensitive, strict usage rules determine what can be forgiven, and changes to tax code are complex.

MGO has created the attached one-page summary to provide basic details on what your organization may be eligible for, and the levels of relief available.

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If you need assistance applying for loans, or applying tax incentives, please do not hesitate to reach out to our team.