California Enacts Workaround of Federal Cap on Deductions for State Taxes

Governor Gavin Newsom signed into law budget legislation that includes a workaround of the $10,000 federal cap on state and local tax deductions. AB 150, known as the Small Business Relief Act, allows certain partnerships and S corporations to elect to pay a 9.3% state income tax in exchange for a tax credit to the entity’s owners for their share of the tax. The workaround is effective for tax years 2021 through 2125, when the deduction cap expires. The law differs slightly from previously introduced proposals. (Governor and Lawmakers Propose SALT Deduction Cap Workarounds.)

The Tax Cuts and Jobs Act (TCJA) of 2017 implemented a $10,000 federal limit on state and local tax deductions. In November 2020, the IRS approved tax mechanisms in several states that allow taxpayers to avoid the federal deduction cap for state and local taxes by using an entity-level tax on owners of pass-through businesses.

The election to pay an entity-level tax applies to an S corporation or an entity that is “taxed as a partnership” in California. This includes limited liability companies, limited liability partnerships, and limited partnerships but excludes general partnerships, publicly traded partnerships, or an entity in a combined reporting group. The law also excludes partnerships from the definition of a “qualified taxpayer.” These definitions limit the applicability of the law.