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Navigating the Future of Tax Policy: A Guide for Corporate Boards

Key Takeaways:

The upcoming election cycle has introduced uncertainty in U.S. tax policy, so corporate boards should be ready for potential changes — namely the expiration of the 2017 TCJA provisions.
Boards should stay flexible in their tax planning. Divergent tax policies from both parties mean the election outcome could yield drastic differences in tax rates, capital gains treatment, and deductions.
Boards should regularly review tax strategies for alignment with corporate goals and regulatory standards, maintaining oversight of the corporate tax posture.
Stakeholders expect companies to be transparent and socially responsible in tax. Boards should prioritize this.

The upcoming U.S. election cycle gives rise to ambiguity in business tax planning. Companies must prepare for a shifting tax landscape while considering differing priorities of Republicans and Democrats regarding U.S. tax policies, such as the approaching expiration of some components of the 2017 Tax Cuts and Jobs Act (TCJA). This environment emphasizes the importance of the board’s oversight role and its understanding of a company’s total tax strategy, emerging compliance complexities, the impact of potential election results and associated tax planning scenarios, and the need for a broad perspective on total tax posture and associated social responsibility of the company.

The TCJA

The TCJA brought significant changes to the U.S. tax code, but many of its provisions are set to expire in 2025. Notably, the corporate tax rate will remain at 21%, but other aspects of the act will sunset, potentially leading to increased tax liabilities for businesses and individuals. Future tax policies will be shaped by the House of Representatives, the Senate, and the White House, and a resulting mix of political power within these bodies will necessitate compromises to pass proposed legislation.

Political Corporate Tax Priority Outlines

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Boards should have a clear understanding of their company’s current tax strategy, which takes into consideration the total tax liability – the composite total of all taxes owed by a taxpayer for the year. Next, consideration of the impact of and response to various tax scenarios and business operations, while ensuring compliance with existing tax law and regulations, should inform oversight of the company’s tax strategy.

Regular reviews of the company’s current tax strategy is a fundamental component of the board’s oversight responsibility. Key questions for management and tax advisors include:

What is the company’s current tax strategy? Do they support the company’s corporate strategy?
Is the tax department evaluating how potential tax scenarios may impact the company?
Is management developing alternative action plans in response?

Tax Considerations and Questions the Board Should be Asking: Big Picture

Election-related risk factors, such as potential tax code changes, are top of mind in boardrooms. Directors know changes may be coming, and proactive management will facilitate a timely response. An effective tax strategy can positively impact the company’s bottom line, help to mitigate risks, and drive growth. Boards play a pivotal role in overseeing these efforts, ensuring management remains vigilant in weighing tax impacts in making informed and responsible strategic decisions. Read on for key tax considerations for boards and the questions they should be asking of management.

Total Tax Posture

Understanding the company’s total tax posture is essential. This includes not only corporate income tax liability but also other tax responsibilities such as payroll, real estate, sales, and value-added taxes (VAT). For example, a company with large net operating losses (NOLs) may not pay corporate income taxes but may still have other tax obligations to consider.

Has risk oversight responsibility for total tax posture been allocated to the full board or a committee of the board? If so, has the company disclosed this at the board or appropriate committee level?
Who is responsible for managing and reporting total tax posture? Does the company have adequate resources to fulfill this responsibility?
What KPIs are being used to track the company’s total tax posture?
How do company KPIs compare to those of competitors?

Global Tax Compliance

Global tax compliance is a complex undertaking, involving issues such as the U.S. global intangible low-taxed income (GILTI) and the base erosion and anti-abuse tax (BEAT). Global tax compliance requires a deep understanding and active monitoring of current and evolving international tax laws and regulations in multiple jurisdictions. Boards need to be proactive in overseeing how management is addressing these complexities to ensure compliance and avoid potential legal and financial risks.

Who is responsible for and how is the company monitoring global tax compliance?
Does the company have adequate resources dedicated to tax compliance?
Have there been instances of noncompliance? How were they resolved?
How does the company monitor evolving domestic and international regulations and legislation impacting compliance?

Tax Transparency and Social Responsibility

Tax transparency and social responsibility are increasingly important in today’s business environment. Companies should strive to be transparent about their tax practices within financial reporting and demonstrate their contributions to society through tax postures. Boards should consider how stakeholders, including investors and the community, see the company’s contribution to social responsibility through taxes. This includes evaluating the company’s tax practices and their alignment within the context of broader social goals.

Who is responsible for drafting and monitoring all tax disclosure?
Is the company conducting any stakeholder engagement around tax transparency and social responsibility?
How is the company using information obtained from stakeholders to adjust its tax planning strategy?
How do the company’s tax contributions align with competitors and stakeholder expectations?

Engineering Value Chain Efficiencies

Proactive tax structuring and value-chain planning are crucial for optimizing tax efficiency. Boards need to consider how much engineering for tax efficiency is acceptable and what might be perceived negatively by the tax authorities or the public. While manipulating the value chain for tax mitigation is generally acceptable, significant legal structuring and non-arm’s-length transactions, such as the use of shell companies or intercompany transfers, may raise speculation and scrutiny.

What options are available for value chain efficiencies?
Does the company have policies regarding tax structuring and value-chain planning?
Were any structuring and planning policies considered and rejected? If so, why did we decide not to adopt them?

Conclusion

As the expiration of the 2017 TCJA approaches and pending November 2024 U.S. election results clarify which political priorities may evolve into legislation, companies must stay informed and prepare for potential changes in tax policy. By understanding their current tax strategy, planning for various domestic and international taxation scenarios, and emphasizing tax transparency and social responsibility, businesses can better navigate the complexities of the tax landscape and ensure compliance. Boards have the responsibility to play a critical oversight role in guiding these efforts and ensuring that the company management remains proactive and responsible in formulating its tax practices and executing its tax strategy.

How MGO Can Help

Our tax team is here to help your board navigate today’s complex tax landscape with tailored strategies that directly address shifting policies and compliance challenges as they arise. From strategic planning and global compliance support to enhancing overall tax transparency and optimizing value chain efficiencies, we provide proactive solutions that align with your company’s goals — as well as your shareholders’.

Be prepared for whatever changes come your way, all while maintaining robust tax oversight and committing to social responsibility and long-term success. Reach out to our team today.

Case Study: How MGO Helped an ISO-Certified Manufacturer Maximize the R&D Credit

Background:

Since Congress created the Research and Development (R&D) credit in the 1980s, it has been an essential tax strategy for companies investing in innovation — providing much-needed support to offset R&D expenses.

Prior to 2022, companies could deduct these expenses in the year paid or elect to amortize them over 60 months. However, a provision included in the Tax Cuts and Jobs Act of 2017 — that didn’t take effect until January 2022 — required businesses to capitalize and amortize these expenses.

This change has been devastating for businesses that invest heavily in innovation. No longer able to write off these expenses immediately, many organizations struggle to maintain cash flow. In some cases, it even threatens business continuity.

While congressional efforts are underway to reverse the requirement to amortize research and experimental expenses, businesses can claim the R&D tax credit to generate tax savings in the meantime.

Challenge:

An International Organization for Standardization (ISO) certified manufacturing company specializes in machining high-tolerance plastics and metals using computer numerical control (CNC) technology. With 96 employees and an annual revenue of $11 million, the company invests heavily in R&D and has incurred roughly $1 million in qualified research expenses.

This manufacturing company had a unique opportunity to claim the R&D tax credit because companies can claim the credit on costs related to implementing ISO to improve processes and quality in their businesses.

Approach:

MGO leveraged its extensive knowledge of R&D tax credits to thoroughly analyze the company’s R&D activities — including implementing continuous improvement and process improvements to streamline quality controls.

By accurately documenting all qualifying expenses and ensuring they align with the four-part test, MGO was able to help the client maximize their R&D credit benefit.

Value to Client:

With MGO’s help, this company successfully claimed the R&D credit — resulting in a net credit benefit of $90,000 in a single year, including federal and state tax credits.

This strengthened the company’s market position by enabling it to reinvest in research, maintain its ISO certification, and improve its ability to fund further innovation, contributing to its long-term competitiveness in the industry.

Your Trusted R&D Tax Credit Advisor

MGO’s tax professionals have more than 30 years of experience helping you document, file, and defend tax credit claims.

Contact MGO today for a complimentary R&D tax credit eligibility analysis to determine if this tax incentive can help fuel innovation and growth in your organization.

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.

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.

Tax Considerations for Financially Distressed Cannabis Companies

Thanks to maturing markets, limited access to capital, and disproportionate tax burdens, many companies in the cannabis industry are facing major challenges in managing their debt and creditors. Without ready access to federal bankruptcy protection, many companies with liquidity challenges are looking at their options. Without careful consideration of the tax consequences of these options, companies may be subject to significant tax traps. Here are several factors to consider to avoid these traps and stay solvent from Tax Partner Barbara Webb.

High cost of debt + high effective tax rate = cash crunch and tough decisions

How did cannabis companies arrive at this decision point? The current cash crunch in the industry has been building for years, precipitated in part by banking regulatory constraints and an abnormally high effective federal tax rate.

As the below chart illustrates, cannabis companies lack access to traditional banking and market rate loans and have turned to alternative, expensive sources of debt financing bearing effective interest rates as high as 20%. In addition, Internal Revenue Code Section 280E essentially taxes the industry on gross margins, such that even a company that would otherwise be in an overall tax loss position may still owe taxes.

Caught in this double bind, even an operationally successful cannabis company may face a difficult choice: service debt timely at the expense of keeping current with taxes, risking tax liens that threaten the license, or pay taxes when due at the price of defaulting on debt and risking the viability of the business overall.

The tax impact of debt restructuring

Restructuring debt is one route for cannabis companies in distress to remain operational, but debt modification carries potential tax traps for the unwary – both borrower and lender. Depending on the relative value of the debt exchanged, the borrower can realize cancellation of debt income. The insolvency exception to recognizing and paying current tax on this income may not be available to a cannabis company, as the fair value of its assets – including intangibles – may still exceed its liabilities. A lender may also experience a taxable event on the refinancing, either in the form of interest income, or gain due to the valuation of equity received in the exchange.

In any debt refinancing situation, both the borrower and the lender should anticipate and plan for complex tax calculations involving debt discounts (I.e., original issue discount, or OID) and the fair value of company equity in order to determine correct tax treatment. To avoid any last-minute surprises or deal delays, both the borrower and the lender should model the tax treatment on both sides.

Sales of distressed assets and the tax impact

Considerations for the borrower:

Are the assets to be sold in a different tax filing entity as the borrower?
Will the flow of cash between entities create a taxable event?

Considerations for the lender:

What is the borrower’s anticipated cash position after paying tax on the sale?
Can cannabis business assets be sold in the jurisdiction’s regulatory environment? Or is a sale restricted to equity?

Assignment of income receipt of equity

If the borrower and the lender agree on a debt workout based on assignment of income, or equity ownership, both parties should understand the borrower’s existing tax structure and the impact the restructuring will have on both sides.

The borrower should assess whether a “change in control” has occurred for tax purposes, as the use of tax attributes may be limited. If an assignment of income is structured as a fee, consider the tax treatment of the payment and deductibility under 280E.

A lender who becomes an owner or part of management should consider:

Depending on how the agreement is structured, the assignment of operating income and participation in management may turn the lender, or the lender’s entity, into a “trafficker” subject to 280E.

The lender should also be cognizant of the borrower’s standing with the taxing authorities and whether the operator can afford both paying down tax liabilities and payments under the terms of the workout. The retention of the cannabis or reseller license that the lender is depending on for cash flow is tied to staying current with state and local taxes. An IRS liability that has progressed to the lien stage unbeknownst to the lender could result in a “sudden” drain of cash from a bank account.

“Workouts” with taxing authorities

Given the current cash crunch in the industry, companies have been known to delay remittance of sales and excise taxes to state and local governments. Companies should be aware that non-payment of these “trustee” taxes can cause a loss of standing to operate legally and carries personal liability for officers and owners of the company. Taxing authorities may have limited sympathy for a distressed taxpayer who falls behind on these types of taxes and taxpayers should pay down any outstanding balances as soon as possible.

If income taxes are past due, it is important to continue to make payments toward the balance on a regular basis. A taxpayer cannot apply for a formal IRS payment plan until a revenue officer is assigned to the case. Also, a taxpayer must usually pay all outstanding taxes that are not overdue and remain “current” on all future taxes in order to establish and remain on an installment agreement. Federal and state revenue officers are generally willing to work with taxpayers in financial distress who act in good faith throughout the process. Engaging a professional representative who understands tax controversy practice and procedure and how to work with revenue officers can make all the difference between establishing a payment plan and facing a tax lien.

How MGO can help

A cannabis company navigating financial distress should engage a tax professional with both industry experience and a high level of tax technical skill to navigate the complex tax impact of a workout or restructuring. MGO’s Cannabis Tax team has both the industry experience and the technical knowledge to assist companies of all sizes during this challenging time.

Tax Highlights of the Inflation Reduction Act

On August 16th, 2022, President Biden signed the Inflation Reduction Act (IRA) of 2022 into law. The Act is a slimmed down version of the Biden Administration’s proposed Build Back Better legislation and addresses several key areas including:

Increasing Internal Revenue Service (IRS) budget
Implementing a corporate tax minimum
Instituting and increasing tax credits focused on investing in green technologies

Notable items that were not addressed in the IRA include removing the $10,000 SALT cap and mandatory capitalization of research and development (R&D) expenses, both provisions of the Tax Cuts and Jobs Act of 2017.

The bill is over 300 pages in length with a number of wide-ranging components. In the following summary we’ll provide the key points that will be affecting taxpayers in the coming years.

Additional funding to the IRS for tax enforcement

One of the most talked-about provisions involves increased funding for the IRS.

Key details:

Approximately $80 billion in funding over the next 10 years for tax services, operations support, business system modernization, and enforcement
- Enforcement – $46 billion
- Operations support – $25 billion
- Business systems modernization – $5 billion
- Taxpayer services – $3 billion
An estimated $124 to $200 billion will be generated from enforcement and compliance efforts
Enforcement is focused on taxpayers – both corporate and non-corporate – with income greater than $400,000

Extension of the business loss limitation of noncorporate taxpayers

The IRA extends the excess business loss limitation for noncorporate taxpayers.

Key details:

Two year extension on IRC Sec. 461(l) until December 31, 2028
IRC Sec. 461(l) limits noncorporate taxpayers from deducting business losses above thresholds that are annually indexed for inflation
These limits are $540,000 for married filing jointly and $270,000 for single and married filing single for the 2022 tax year
Suspended amounts are converted to net operating losses and may be able to be used in subsequent years

Excise tax on repurchases of corporate stock

The IRA includes a 1% excise tax on stock repurchases by domestic public companies listed on an established securities market. The tax applies to repurchases executed after December 31st, 2022.

Key details:

1% excise tax on the full market value (FMV) of stock repurchased by publicly traded US corporations
Will impact redemptions and certain acquisitions and repurchases of publicly traded foreign corporation stock
Not an income tax for purposes of ASC 740
Includes special rules for “applicable foreign corporations” and “surrogate foreign corporations”
Notable exceptions:
- Stock is contributed to employer sponsored retirement plan
- Stock repurchase is part of a corporate reorganization
- Total value of stock repurchased during the taxable year does not exceed $1 million
- Repurchase by securities dealer in ordinary course of business
- If the repurchase qualifies as a dividend
- If the repurchase is by a regulated investment company (RIC) or a real estate investment trust (REIT)

15% corporate alternative minimum tax

The IRA reinstates the corporate alternative minimum tax (AMT) for large corporations, which had been previously eliminated by the Trump Administration’s Tax Cuts and Jobs Act.

Two key elements to note is that this revised AMT only impacts corporations with annual profits exceeding $1 billion, and includes carve-outs for certain manufacturers and subsidiaries of private equity firms.

Key details:

15% tax on adjusted financial statement income (i.e., this would be a book minimum tax)
Affects tax years beginning after December 31, 2022
Applies to corporations with profits over $1 billion based off adjusted financial income
For US corporations with foreign parents, it would apply to income earned in the US of $100 million or more of average annual earnings in three prior years and where the overall international financial reporting group has income of $1 billion or more
Treatment of split offs remains uncertain. Even though these are tax-free reorganizations for tax purposes, gain is recorded for financial accounting purposes
Joint Committee on Taxation expects that this new tax would apply to only about 150 corporate taxpayers, approximately equal to 30% of the Fortune 500

Tax credit additions and modifications

A significant number of provisions add or enhance credits and incentives that pertain to domestic research and green energy initiatives. Noteworthy changes include:

Increased small business payroll tax credits for research activities:

Qualified payroll tax credit for increasing research activities raised from $250,000 to $500,000
- First $250,000 will be applied against the FICA payroll tax liability. Second $250,000 will be applied against the employer portion of Medicare payroll tax.
- Applies for taxable years beginning after December 31, 2022
- Limited to tax imposed for calendar quarter with unused amounts being carried forward
Qualifying small businesses are required to have less than $5 million in gross receipts in current year and no gross receipts prior to the 5 year period ending with the current year

Green initiative tax credits and incentives:

Credits for purchasing new and previously-owned clean vehicles
Extension of IRC Sec. 45L – New Energy Efficient Home Credit – extended to qualified new energy efficient homes acquired before January 1, 2033. Increase value of available credit for single-family homes to $2,500 and modified the credit available for multi-family homes.
Extension, increase, and modifications to IRC Sec. 25C nonbusiness energy property credit
Extension and modification of IRC Sec. 25D residential clean energy credit
IRC Sec. 48 energy credit for businesses and investors
- Expansion of qualifying property, extension of credit including phasedown and phaseout rules, and introduction of incentives
Credit for producing energy from renewable sources (IRC Sec. 45)
- Retroactive for facilities placed in service after December 31, 2021
- Extends beginning of construction deadline to projects beginning construction before January 1, 2025 including solar energy facilities
Increased energy credit for solar and wind facilities in certain low-income communities
New credit for clean hydrogen production
New credit for zero-emission nuclear power
Extension of incentives for biodiesel, renewal diesel, and alternative fuels
Extension of biofuel producer credit
New income and excise tax credits allowed for sustainable aviation fuel
Modification of IRC Sec. 179D – Energy Efficient Commercial Buildings Deductions
- Modification of building qualifications
- Deduction increased from $1.88 per square foot to up to $5 per qualified square foot
Changes in depreciation for certain green energy properties

Final thoughts

The Inflation Reduction Act should have wide-ranging impacts on taxpayers, especially large corporations and high-net-worth individuals. In the coming weeks our tax leaders will dive into the specifics of the legislation, outline immediate and long-term impacts, and provide tax-planning strategies and considerations.

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.