California Gov. Gavin Newsom (D) recently announced tax incentive and relief proposals for businesses, including a proposal aimed at helping S corporations to circumvent the federal cap on the state and local tax deduction.
The proposals are included in Newsom's $4.5 billion “Equitable Recovery for California’s Businesses and Jobs” plan, which is part of his proposed budget for fiscal 2022. According to a January 5 release, the plan would commit $777.5 million to the California Jobs Initiative, which includes a plan to mitigate the federal Tax Cuts and Jobs Act's $10,000 cap on the SALT deduction specifically for "S-corporation shareholders."
Although no documents containing details have been provided for the SALT cap workaround proposal, a spokesperson for the California Department of Finance told Tax Notes that the concept is that S corporations would be able to elect to pay a newly created 13.3 percent state tax on income, thereby reducing the income that is passed through to shareholders. Shareholders would then get a state tax credit equal to 13.3 percent of their "passed-through income," the department said.
The result is that electing taxpayers' liability would be reduced "relative to current law." The proposal's impact on the state would be revenue-neutral or result in a slight revenue gain, according to the department.
Following the TCJA’s passage, some states have sought to circumvent the cap by effectively shifting the point at which they tax passthrough entity income from the owners to the entity itself, allowing passthroughs to pay an additional state tax on income at the entity level and then claim a federal deduction for that tax that’s not subject to the SALT cap (the cap applies to individual income tax payers). The businesses’ owners then could claim a state income exclusion or tax credit to offset the state tax payments made at the entity level on their passthrough income. The IRS in November 2020 released guidance the effect of which is to allow that approach, and Newsom is proposing to adopt it for California.
Darien Shanske, a tax expert at the University of California, Davis, told Tax Notes in a January 6 email that the IRS guidance and the example provided by laws previously approved by other states to allow the passthrough circumvention of the SALT cap make it “really a no-brainer to do this” in California.
However, Shanske added, “It is interesting that the proposal focuses on S corporations, which are only one kind of passthrough that could benefit. . . . I am assuming the idea is that S corps are more of a proxy for small business owners, but it is a noisy proxy.”
“In any event, even to benefit from mitigating the SALT cap, the shareholders have to be pretty well off,” Shanske said, adding that exclusively providing the SALT cap workaround to small businesses wouldn’t make the best use of it.
“Mitigating the SALT cap is progressive because it is an (appropriate) federal subsidy for states to rely on progressive taxation, and so there is no reason to try to pick and choose between SALT workaround beneficiaries,” Shanske said.
Shanske also argued that states adopting such workarounds should consider clawing back some of the value of the TCJA’s 20 percent passthrough deduction for passthrough owners in return for facilitating mitigation of the cap.
Other proposals in the California Jobs Initiative intended to bolster businesses include:
increasing resources for the California Competes tax credit, which is provided to qualifying businesses that locate, hire, and expand in the state ($430 million);
extending the state's Main Street Hiring Tax Credit program, which was legislatively approved in 2020 to provide tax credits to businesses that meet the credit's criteria and hire qualifying employees ($100 million);
providing additional funding for small business loan and disaster loan guarantees provided by the California Infrastructure and Economic Development Bank’s Small Business Finance Center ($50 million) and for the California Rebuilding Fund ($50 million);
expanding sales tax exclusions for manufacturing equipment, with a focus on encouraging green technology and transportation innovation ($100 million); and
increasing funding for the state’s Dream Fund to provide grants for disadvantaged entrepreneurs ($35 million).
COVID Relief Provisions
Newsom is also proposing to use some $575 million to fund additional COVID-19 relief grants for small businesses, on top of the $500 million previously appropriated to the program in November 2020.
“This program provides grants anywhere from $5,000 to $25,000,” Newsom said January 5 via a video link. He urged lawmakers to approve the increased funding, saying, “We want to build on that program that’s just been launched, in partnership with the Legislature.” He noted that the deadline for the program’s first $500 million in grants was recently extended through January 13.
The governor is also calling for $70.6 million in business fee waivers for some 59,000 restaurants and bars, as well as for 53,000 hair salons, barber shops, and similar businesses that have been heavily affected by the pandemic and lockdowns.
“Those fees we want to waive into the new year, and we’re looking to do some immediate support in that space,” Newsom said.
The proposals come after other measures taken by the state that include sales tax relief and an expansion of a first-year waiver of the state’s minimum franchise tax, temporarily extending it to partnerships and limited liability companies. Also, lawmakers and Newsom in 2020 approved legislation to exclude forgiven federal Paycheck Protection Program loans from being counted as taxable income.