How to Use the California SALT Cap Workaround

The Tax Cuts and Jobs Act of 2017 established a $10,000 annual limit on the federal deduction for state and local taxes, known as the SALT deduction. This cap particularly affected individuals in states with higher income and property taxes, resulting in a higher federal tax liability for many.

In response, California created a workaround effective for tax years 2021 through 2025. The law will be repealed sooner if the federal SALT deduction limitation is repealed. This solution allows state income taxes to be paid at the business level, altering how those taxes are treated for federal purposes and providing relief to the individual owners.

The California Pass-Through Entity Elective Tax

The core of California’s solution is the pass-through entity (PTE) elective tax. This is an optional tax that certain types of businesses can choose to pay on behalf of their owners. By making this election, the business pays a state tax based on its owners’ share of income, and the business can then deduct this payment as an ordinary business expense on its federal tax return. This effectively shifts the state tax payment from a personal, non-deductible expense for the owner to a fully deductible expense for the business, bypassing the $10,000 individual SALT cap.

Eligibility for this election is specific. The entities that can make the choice are partnerships, S corporations, and limited liability companies (LLCs) that are treated as either partnerships or S corporations for tax purposes. Conversely, entities such as publicly traded partnerships, C corporations, and sole proprietorships are not eligible. The law also specifies that businesses required to be part of a combined reporting group are excluded.

The owners themselves must also meet certain criteria to be considered a “qualified taxpayer.” A qualified taxpayer is an individual, estate, or trust that consents to have the entity pay the tax on their share of income. A corporation cannot be a qualified taxpayer. The consent of each owner is handled separately; if one owner chooses not to participate, the entity can still make the election and pay the tax for the other consenting owners.

Information and Calculations for the Election

Before an entity can make the election, it must first calculate the tax base, referred to as the “qualified net income.” Qualified net income is determined by adding together the pro-rata or distributive shares of income for each of the owners who have consented to the PTE tax election. This includes the share of income, guaranteed payments, and capital gains subject to California personal income tax.

Once the qualified net income is determined, the entity applies California’s specific PTE tax rate of 9.3%. The calculation is straightforward: the total qualified net income is multiplied by 9.3% to arrive at the total elective tax amount due. For instance, if an S corporation has two consenting shareholders with a combined qualified net income of $500,000, the PTE tax would be $46,500.

The Election and Payment Process

The decision to use the PTE tax workaround is an annual election that must be made on an original, timely-filed tax return for the entity, including extensions. The election is made by filing FTB Form 3804, Pass-Through Entity Elective Tax Calculation, with the entity’s main tax return, such as Form 565 for partnerships or Form 100S for S corporations. Once made for a given year, the election cannot be revoked.

Payment of the PTE tax has specific deadlines. For tax years through 2025, the tax is paid in two installments. The first payment is due by June 15th of the taxable year and must be the greater of $1,000 or 50% of the elective tax paid in the prior year. If the entity did not pay the elective tax in the prior year, the first payment must be at least $1,000. Failure to make this prepayment makes the entity ineligible to make the PTE election.

The second payment is due by the original due date of the entity’s tax return, which for calendar-year entities is March 15th of the following year. This final payment covers the remaining balance of the PTE tax calculated for the year. Payments can be made electronically through the California Franchise Tax Board’s (FTB) Web Pay system.

Claiming the Credit on Personal Returns

After the pass-through entity pays the elective tax, the entity is responsible for reporting each owner’s share of the tax payment on their California Schedule K-1. This document provides the owner with the specific amount of the credit they are entitled to claim on their personal state tax return. The K-1 serves as the official notification from the business to its owner.

The owner then uses this information to claim a nonrefundable tax credit on their personal California income tax return, Form 540. To do this, they must complete and attach Form FTB 3893, Pass-Through Entity Elective Tax Credit. The credit directly reduces the amount of California income tax the owner owes for that year.

The PTE tax credit is applied to the owner’s tax liability after any credits for taxes paid to other states. The credit is nonrefundable, meaning it can reduce an owner’s tax liability to zero but cannot generate a refund. If the credit exceeds the owner’s tax liability for the year, the unused portion can be carried forward for up to five years.

The ultimate benefit of this process is realized on the owner’s federal tax return. The state tax paid by the entity reduces the total pass-through income reported to the owner on their federal Schedule K-1. This reduction in federally reported income lowers the owner’s federal adjusted gross income (AGI), leading to a lower federal tax bill. This effectively allows the owner to receive the full benefit of the state tax payment as a deduction at the federal level.