On February 9, 2022, California Governor Gavin Newsom signed Senate Bill 113 (SB 113) into law. SB 113 makes various changes to California's tax law affecting family businesses and offers valuable tax planning opportunities that business owners may wish to take advantage of.
Specifically, SB 113 reinstates the business tax credits and net operating loss (NOL) deductions previously limited by legislation from 2020, Assembly Bill 85 (AB 85). SB 113 also expands California's pass-through entity (PTE) tax.
Reinstatement of NOL Deductions and Tax Credits
Signed into law in 2020, AB 85 suspended the use of NOLs during tax years 2020-2022 for taxpayers with California source taxable income of $1 million or more. AB 85 also limited the use of certain business tax credits, including research and development credits, to $5 million annually for tax year 2020-2022. SB 113 removes these limitations for tax year 2022.
Expansion of Elective Pass-Through Entity Tax
The elective PTE tax was California's workaround to the state and local tax deduction cap of $10,000 created by the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA). The initial state law allowing the PTE tax was passed in 2021 as Assembly Bill 150, but many in the business community felt the legislation fell short in providing the relief required after TCJA.
SB 113 is seen as the answer to those continued complaints. Prior to passage of SB 113, qualifying PTEs could elect annually to pay entity-level state tax on income. The credit for payment of the tax passed through to qualified taxpayers holding an interest in the entity, thereby reducing such taxpayers' individual California income tax.
SB 113 expands the benefit of the elective PTE tax and who may take advantage of it in the following ways:
- Eligibility for the election is expanded to include entities that have partnership as a partner, member, or shareholder.
- Certain disregarded entities, including single-member liability companies, may meet the requirements for a "qualified taxpayer."
- The tax credit would be applied to reduce net tax after factoring in credits for taxes paid to other states, effective for tax years beginning on or after January 1, 2022.
- The tentative minimum tax limitation applicable to the PTE tax is repealed for tax years beginning on or after January 1, 2021.
Planning Opportunities for Family Businesses
Family business owners should consult with their tax professional to determine whether the removal of the NOL and business tax credit limitations provide an opportunity for tax savings in the 2022 tax year. Additionally, the changes to the elective PTE tax may allow more family businesses to be eligible for the election.
If a particular family business is not eligible as currently structured, even with the more liberal requirements, there may be adjustments to the business structure that would result in the entity qualifying. Depending on the extent of the benefit to the individual taxpayer owners of eligibility, updates to the entity structure of the family business may be well worth the effort.