How to Report AB150 Payments on State and Federal Tax Returns

California’s AB150 introduced the Pass-Through Entity Elective Tax, allowing certain businesses to manage state and federal tax liabilities more efficiently. This provision lets qualifying entities elect a different taxation method, potentially benefiting business owners. Accurate reporting is essential to ensure compliance and avoid audits or missed deductions.

Qualifying Entities

Pass-through entities—S corporations, partnerships, and LLCs taxed as partnerships—may qualify for California’s Pass-Through Entity Elective Tax. Sole proprietorships and single-member LLCs disregarded for tax purposes do not qualify. The election is available only to entities with owners who are individuals, trusts, estates, or other pass-through entities, excluding publicly traded partnerships.

An entity must conduct business in California and have income subject to the state’s personal income tax. Even entities formed outside California may be eligible if they have California-source income. The election must be made annually with unanimous owner consent.

The tax is calculated at 9.3% of qualified net income, which includes each consenting owner’s distributive share. Payments are due in two installments: the first by June 15 of the taxable year (50% of the prior year’s tax or $1,000, whichever is greater) and the second by the entity’s original tax return due date.

Filing Requirements

Once an entity opts in, proper documentation and timely submission of forms are necessary. The election must be made on the entity’s original, timely filed tax return—extensions are not allowed. Failure to elect by the due date means the entity cannot amend its return to opt in later.

Payments are reported on the entity’s California tax return using Form 3804. Each owner’s share of the tax is reported on Schedule K-1 (Form 565 or 100S) for claiming a credit on their individual state tax return. Errors can delay processing, and overpayments may be applied to future liabilities or refunded.

Entities must also meet estimated tax payment requirements. Missing the June 15 prepayment deadline makes the entity ineligible for the election that year. Late second installments incur penalties and interest, with a 5% penalty plus 0.5% per month on unpaid amounts.

Tax Treatment on State Returns

California treats Pass-Through Entity Elective Tax payments as a credit against an owner’s state tax liability. Owners who consent receive a nonrefundable credit on their California return. If the credit exceeds the tax due, the unused portion carries forward for up to five years.

The tax paid at the entity level reduces owners’ California taxable income, lowering the amount subject to the state’s progressive tax brackets. However, it does not affect other state-level deductions or California’s alternative minimum tax (AMT). Unlike federal AMT, California’s version allows full utilization of the credit.

The elective tax also impacts basis calculations, as it is treated as an entity-level expense. This reduces the distributive share of income reported to owners, affecting basis tracking for partners or S corporation shareholders. Proper recordkeeping is necessary to avoid discrepancies when reconciling state and federal tax positions.

Federal Return Considerations

The federal treatment of California’s Pass-Through Entity Elective Tax requires careful handling. Since the tax is paid at the entity level, it is generally deductible as an ordinary business expense under IRC Section 162, reducing the pass-through entity’s taxable income before distribution to owners.

The IRS confirmed in Notice 2020-75 that state-imposed entity-level taxes are deductible for federal purposes. However, this deduction reduces the amount of income reported to owners, which can impact the Section 199A qualified business income (QBI) deduction. Since the elective tax lowers net income, it may reduce the amount of QBI eligible for the 20% deduction. Entities and owners must weigh the trade-offs between securing the federal deduction and preserving QBI.

Claiming Credits and Deductions

Maximizing the benefits of the Pass-Through Entity Elective Tax requires proper application of credits and deductions on state and federal returns. Owners must accurately claim the credit on their California return while considering its impact on federal deductions.

Claiming the Credit on California Returns

Owners report their share of the elective tax credit on their personal California tax return using Form 3804-CR. The credit offsets state tax liability but is nonrefundable. Any excess carries forward for up to five years.

Owners with tax liabilities in multiple states must consider how California’s credit interacts with other state tax obligations. Some states provide a credit for taxes paid to other jurisdictions, but since California’s elective tax is imposed at the entity level, it may not qualify for such credits in certain states. Taxpayers should review their resident state’s rules.

Deducting the Tax on Federal Returns

For federal tax purposes, the elective tax is deducted at the entity level as a state tax expense, reducing taxable income passed through to owners. This deduction is beneficial given the $10,000 cap on state and local tax (SALT) deductions for individuals, allowing business owners to bypass this limitation. The IRS confirmed this treatment in Notice 2020-75.

However, the deduction lowers reported income, which can affect other tax calculations. A lower reported income may impact eligibility for deductions or credits tied to adjusted gross income (AGI), such as the net investment income tax (NIIT) or QBI deduction. Owners should evaluate how the deduction affects their overall tax position and consider strategies to optimize their federal tax outcome.