What is the AB 150 Pass-Through Entity Tax?

California’s Assembly Bill 150 (AB 150) created an elective pass-through entity (PTE) tax in response to a federal tax law change. The 2017 Tax Cuts and Jobs Act introduced a $10,000 limit on the state and local tax (SALT) deduction for individuals. This SALT cap particularly affected taxpayers in higher-tax states, and the PTE tax provides a workaround for owners of certain businesses.

The law allows eligible business entities to pay a California income tax at the entity level for their owners. This payment is then deducted as a business expense on the entity’s federal return, reducing the income that passes through to the owners. Consequently, the owners’ federal taxable income is lowered, and they receive a credit on their personal California tax returns for the tax paid. This election is made annually and is irrevocable for that tax year.

Determining Eligibility for the Election

Participation in the PTE elective tax is limited to specific business structures, referred to as “qualified entities.” These include S corporations, partnerships, and limited liability companies (LLCs) that are taxed as either a partnership or an S corporation. The business must be actively operating in California and required to file a state tax return.

Certain business structures are excluded from making this election, such as publicly traded partnerships. If an entity has a partnership as an owner, that owner’s share of income is not included in the PTE tax calculation. Businesses that are part of a combined reporting group are also excluded.

The owners of these qualified entities are “qualified taxpayers,” which can include individuals, fiduciaries, estates, or trusts that are partners, members, or shareholders. A single-member limited liability company (SMLLC) owned by one of these is also a qualified taxpayer. The election is made by the entity itself, and consent from all owners is not required.

Calculating the Elective Tax

The elective tax rate is 9.3% of the entity’s qualified net income. This rate is applied to the total income attributable to the owners who are qualified taxpayers. The tax paid by the entity is in addition to other state taxes, such as the 1.5% tax on net income for S corporations or the annual minimum franchise fee.

“Qualified net income” is the sum of each qualified taxpayer’s pro rata or distributive share of the entity’s income and any guaranteed payments subject to California personal income tax. It includes various forms of income, such as profits from business operations, interest, and dividends that flow from the entity to its owners.

Consider an S corporation with two equal shareholders, both of whom are California residents. If the S corporation generates $500,000 in net income, the entity’s qualified net income would be the total $500,000. To determine the elective tax, the entity would multiply this amount by the 9.3% rate, resulting in a PTE tax of $46,500.

The $46,500 paid in state tax is treated as an ordinary and necessary business expense, which the S corporation deducts on its federal return. This deduction reduces the entity’s federal taxable income before the remaining profit is passed through to the shareholders, lowering their individual federal income tax liability.

Making the Election and Paying the Tax

The decision to use the PTE tax is made annually on the entity’s original, timely-filed California tax return for the year of the election. The business officially declares its choice when filing Form 100S for S corporations or Form 565 for partnerships. The election is irrevocable for the chosen tax year.

For tax years 2022 through 2025, the payment of the elective tax is structured into two installments. The first payment is due by June 15th of the taxable year. This payment must be the greater of $1,000 or 50% of the elective tax paid in the prior year, and failure to make it correctly can make the entity ineligible for the election.

The second installment, which covers the remaining balance of the PTE tax, is due by the original due date of the entity’s tax return, typically March 15th for calendar-year entities. Filing an extension for the tax return does not extend the deadline for this final payment. Timely payment of both installments is required for the election to be valid.

Entities can submit these payments through methods provided by the California Franchise Tax Board (FTB). One method is using the FTB’s Web Pay platform for electronic transfers from a bank account. Alternatively, businesses can mail a check or money order with Form FTB 3893, the PTE Elective Tax Payment Voucher.

Claiming the Personal Tax Credit

After the entity pays the elective tax, qualified taxpayers receive a nonrefundable tax credit on their personal California income tax returns (Form 540). This credit is equal to their share of the 9.3% tax paid by the entity on their behalf. The purpose of the credit is to prevent double taxation at the state level on the same income.

The business entity is responsible for communicating the credit amount to each of its owners. This information is reported on the owner’s California Schedule K-1 (Form 100S for S corporation shareholders or Form 565 for partners). The Schedule K-1 details the specific amount of the PTE tax credit they are entitled to claim.

To claim the credit, the qualified taxpayer must file Form FTB 3804-CR, Pass-Through Entity Elective Tax Credit, with their personal state income tax return. The credit is nonrefundable, meaning it can reduce the taxpayer’s liability to zero but will not result in a refund on its own.

If the tax credit is larger than the owner’s California tax liability for that year, the unused portion is not lost. The law includes a five-year carryover provision for any excess credit. This allows the taxpayer to apply the remaining credit amount to their tax liability in any of the next five tax years.

Business owners should be aware that the PTE tax is a temporary measure. The law is operative for tax years through 2025 and is scheduled to become inactive at the beginning of 2026. This expiration coincides with the federal SALT cap limitation, which the PTE tax was designed to address.