California’s Passthrough Entity (PTE) Elective Tax offers a valuable opportunity for S corporations, partnerships, and LLCs taxed as S corporations or partnerships to reduce the overall tax burden on their owners. By allowing state taxes to be paid at the entity level, the election can help owners bypass the $10,000 federal SALT deduction cap and claim a California tax credit, providing both federal and state tax benefits.
How the PTE Elective Tax Works
Eligible entities that make the PTE tax election pay tax at 9.3% on qualified net income at the entity level. In exchange, consenting owners receive a nonrefundable California income tax credit equal to their share of the tax paid. This credit can offset not only tax on income from the entity, but also other California income tax liabilities. If not fully used in the year generated, the credit can carry forward for up to five years.
Resident owners benefit from a credit based on all entity income, while nonresident owners’ credit is limited to California-source income.
2025 Prepayment Requirement
To qualify for the passthrough entity (PTE) tax election for the 2025 tax year, entities must make a prepayment by June 16, 2025. Taxpayers eligible for the Los Angeles County wildfire disaster extension have until October 15, 2025.
The required prepayment is the greater of:
- $1,000, or
- 50% of the tax due for the prior tax year
The balance of the PTE tax is due with the entity’s tax return. However, to maximize the tax benefit, it is recommended that entities pay the full PTE tax amount by the end of the tax year—December 31 for calendar-year filers.
Important: Unless the law is extended, 2025 is the last year that entities will be able to make the election. However, even if the passthrough entity tax election is not extended, any unused carryovers remaining will still carry over for five years from the year the credit was generated.
No election in the prior year
If the entity did not make the election for the 2024 tax year, then only $1,000 is due by June 16, 2025, to preserve the right to make the election for 2025. This is true even if the entity had made the election for 2023 or prior years.
Making the prepayment preserves the right to make the election but does not obligate the entity to do so. If the election is not ultimately made, the prepayment can be applied to other entity-level tax liabilities or refunded, though refunds may take several months.
50% prior-year threshold
The 50% of prior-year tax requirement is based on the passthrough entity tax amount that is due for the prior tax year. For S corporations and LLCs taxed as S corporations, this amount is shown on line 29 of the corporation’s 2024 Form 100S. For partnerships, this amount is shown on line 25 of the partnership’s 2024 Form 565. For LLCs taxed as partnerships, this amount is shown on line 4 of the LLC’s 2024 Form 568.
There are no exceptions to the 50% of prior-year threshold even if the underpayment is a small amount or if the 2024 passthrough entity tax was unusually large, for example, due to a one-time gain.
If a taxpayer underestimates their passthrough entity tax liability for a 2024 return that is still on extension or later amends a 2024 return to increase the liability, the 50% threshold is based on the amount that is ultimately reported on the final 2024 return. If a taxpayer does not meet the 50% threshold, then the entity is ineligible to make the election for 2025. Although legislation was introduced last year to ease this all-or-nothing treatment, the legislation was not enacted.
This is why we strongly recommend that taxpayers add a cushion to the original prepayment amount paid so should the entity discover that it underestimated or underpaid the prior-year’s tax, they will not automatically be ineligible to make the election for the current year.
Prepayment does not require election to be made
Remember that a taxpayer that makes the prepayment is not bound to make the election when it timely files its return (including extensions). If the taxpayer makes a June 16, 2025, prepayment and either chooses not to make the election when it files its 2025 return or finds that it is ineligible to make the election, the prepayment can be applied to any of the entity’s other outstanding tax liabilities at the time it files its return (e.g., the S corporation 1.5% net income tax or the LLC gross receipts fee). Any remaining amount will be refunded to the entity after the entity’s return is processed by the FTB. This may take up to eight months after filing, so it’s important to warn your clients that the payment will not be refunded as soon as the return is filed.
Short tax years
If the entity is formed after June 16, 2025, or changes its entity type (e.g., from SMLLC to multimember LLC) effective after June 16, 2025, it is not required to make a prepayment for the 2024 tax year if its short tax year does not include June 16, 2025.
Retroactive S corporation elections
A question that often arises is what happens if an SMLLC makes an S corporation election effective January 1, 2025, but it hasn’t been approved by the IRS by the June 16 prepayment date. The FTB has confirmed that if an SMLLC wants to make a retroactive S corporation election for 2025 and its S corporation election has not yet been approved by June 16, 2025, the SMLLC should make a $1,000 prepayment by June 16, 2025, to preserve its ability to make the 2025 passthrough entity tax election once the S corporation election is approved.
As long as the entity is a “qualified entity” (e.g., an S corporation) by the time the election is made on its 2025 tax year return, the FTB will apply the previously made prepayment (made while the entity was an SMLLC) to the S corporation’s account.
Benefits of the Election
One of the primary advantages of opting into PTE is the ability to circumvent the $10,000 State and Local Tax (SALT) deduction cap on federal tax returns. The tax paid at the entity level is fully deductible, thereby reducing the owners’ federal taxable income. However, owners must add back this tax when calculating their California taxable income.
Decision Points for Owners
Owners should consider several factors before consenting to this arrangement:
- The potential to fully utilize the tax credits over the next five years.
- Their income levels and whether they expect to have sufficient California tax liability against which the credit can be used.
- The implications of nonresident withholding and their overall cash flow.
Payment method
The prepayment must be made by:
- Check along with the 2025 Form 3893, Pass-Through Entity Elective Tax Payment Voucher (although remember that S corporations that are subject to mandatory electronic payments cannot write a check);
- WebPay. Make sure the correct tax type and tax year are chosen. The entity will be ineligible to make the election if the owner mistakenly checks the individual estimated tax payment option; or
- Electronic funds withdrawal (EFW) using tax preparation software.
However, if a taxpayer inadvertently directs a payment to be applied to another entity tax (e.g., estimated tax, S corporation tax, or the LLC fee or tax), the taxpayer can contact the FTB to have the payment transferred and applied to the entity’s passthrough entity tax.
Conclusion
The California Passthrough Entity Elective Tax presents a valuable opportunity for eligible business owners to manage their tax liabilities effectively. By allowing the payment of state taxes at the entity level, it offers a strategic way to maximize federal tax deductions and manage state tax credits efficiently. Owners should carefully evaluate their circumstances and potential benefits before opting in, as the election has both immediate and long-term financial implications.
Additional Information
For additional information and FAQs, see the FTB’s webpage “Help with pass-through entity (PTE) elective tax” at:
www.ftb.ca.gov/file/business/credits/pass-through-entity-elective-tax/help.html.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Red Oak CPAs assumes no liability for actions taken in reliance upon the information contained herein.