The SALT Cap Problem and California’s AB 150 Fix

When the Tax Cuts and Jobs Act of 2017 capped the state and local tax (SALT) deduction at $10,000 per return under IRC §164(b)(6), it hit California taxpayers hard. A business owner earning $500,000 through an S corp or partnership was suddenly losing tens of thousands of dollars in federal deductions they’d previously taken for granted. The $10,000 cap applied to individuals — but it didn’t apply to taxes paid by the business entity itself.

California spotted that gap. In 2021, Governor Newsom signed AB 150, creating the pass-through entity elective tax (often shortened to PTE or PTET). The concept is straightforward: instead of each owner paying California income tax on their share of the entity’s income on their personal return, the entity itself pays the tax. That entity-level payment becomes a deductible business expense on the federal return — no SALT cap restriction. The owners then receive a credit on their California individual returns for the tax the entity already paid.

The IRS confirmed in Notice 2020-75 that it would respect these state-level entity elections, which gave California (and about 35 other states with similar programs) the green light. It’s one of the few areas where state tax law and federal tax planning genuinely align in the taxpayer’s favor.

Who Qualifies: Qualified Entities and Their Members

Not every California business can make this election. The FTB limits it to what it calls “qualified entities” — and the member requirements matter just as much as the entity type.

Eligible Entity Types

• S corporations — the most common users of the PTE election
• General partnerships
• Limited partnerships (LPs)
• LLCs taxed as partnerships — including multi-member LLCs that file Form 1065 federally

Who’s Excluded

Single-member LLCs don’t qualify. Neither do publicly traded partnerships. If the entity has a partnership or an LLC as a direct partner or member (as opposed to an individual, estate, or trust), those non-qualifying members’ income gets excluded from the PTE tax calculation — the entity can still elect, but only the “qualified” members’ shares count.

Qualified members include individuals, fiduciaries (estates and trusts), and — this catches some people off guard — certain IRAs and tax-exempt organizations. The key test: can the member actually use a California income tax credit? If the answer is no, their income doesn’t get included in the PTE base.

Making the Election: Form 3804 and the Annual Decision

The PTE election is made on Form 3804, which the entity files with (or before) its California return. A few things to know about the mechanics.

First, this is an annual election. There’s no multi-year commitment. You elect for 2025, and you can skip 2026 if the math doesn’t work out. That flexibility matters because the benefit depends on each year’s income level, each owner’s personal tax situation, and whether the federal SALT cap is still in place.

Second, once you make the election for a given tax year, it’s irrevocable for that year. You can’t file Form 3804, see how the numbers shake out, and then withdraw the election if you don’t like the result. Commit or don’t.

Deadline Mechanics

The election is made by the original due date of the entity’s return (without extensions). For calendar-year entities, that’s March 15 for S corps and partnerships. But there’s a twist: the FTB also requires a prepayment by June 15 of the tax year if you want to elect for that year. We’ll cover prepayments in detail below.

Form 3804 reports the qualified net income of all electing qualified members and calculates the entity-level tax. The entity attaches it to its California return (Form 100S for S corps, Form 565 for partnerships).

The Tax Rate: 9.3% on Qualified Net Income

California’s PTE tax rate is a flat 9.3% — the same as the state’s top marginal rate for most pass-through income brackets. The tax is calculated on the combined “qualified net income” of all consenting qualified members.

Qualified net income is each qualified member’s pro-rata or distributive share of income, determined under California tax law (not federal). If a member has a net loss for the year, that loss is treated as zero for PTE purposes — you can’t use one member’s loss to offset another member’s income in this calculation. Each member’s share is computed separately, floored at zero, and then the positives are added together.

Here’s a detail that trips people up: the 9.3% rate applies regardless of whether the individual member would have been in a lower California bracket on their personal return. A member whose share of income is $30,000 would normally pay well below 9.3% on that amount individually. But under the PTE election, the entity pays 9.3% on all qualified income. The member then gets a dollar-for-dollar credit — so they’re made whole on the California side. The real benefit is on the federal side, where the entity’s tax payment is deductible.

Claiming the Credit: Form 3804-CR

This is where it comes together for the individual owners. After the entity pays the PTE tax and files Form 3804, each qualified member claims their share of that tax as a credit on their personal California return using Form 3804-CR.

The credit equals the member’s pro-rata share of the PTE tax paid by the entity. It’s a nonrefundable credit — meaning it can reduce your California tax to zero but won’t generate a refund by itself. However (and this is the good part), any excess credit that you can’t use in the current year carries forward for five years.

How It Flows Through

The entity reports each member’s share of the PTE tax on their Schedule K-1 (California version). The member picks up that amount and enters it on Form 3804-CR, which gets attached to their Form 540 (California personal income tax return). The credit offsets the California tax the member would otherwise owe on that same pass-through income.

Think of it as a wash on the California side: the entity paid 9.3%, the member gets a 9.3% credit. The member’s California tax bill on that income nets to roughly the same as if they’d just paid it personally. The savings show up on the federal return.

Prepayment Requirements: The June 15 Deadline

California added a prepayment wrinkle that catches first-time electors off guard. To make the PTE election for a given tax year, the entity must make a prepayment by June 15 of that same tax year.

For the 2025 tax year, that means a payment is due by June 15, 2025. The minimum prepayment is the greater of $1,000 or 50% of the PTE tax paid for the prior year (if the entity elected in the prior year). For entities making the election for the first time, the minimum is $1,000.

This isn’t just a suggested deposit — it’s a condition of the election. Miss the June 15 prepayment, and the FTB treats the election as invalid for the entire year. No do-overs. We’ve seen businesses lose the election because someone forgot to calendar the June deadline, which is months before the entity return is even due.

The remaining balance of the PTE tax is due when the entity files its return (or by the original return due date). Overpayments from the prepayment can be applied to the final amount.

Federal Tax Treatment: Where the Real Savings Live

The entire point of the PTE election is what happens on the federal return. When the entity pays the California PTE tax, that payment is treated as a state tax paid by the entity — not by the individual members. And entity-level state taxes are deductible as a business expense under IRC Section 164, without any SALT cap limitation.

On the federal side, the entity deducts the PTE tax payment, which reduces the taxable income flowing through to each member on their federal K-1. The members report less income federally, which means less federal tax. The California credit on Form 3804-CR makes the members whole on the state side.

Net Effect

The federal tax savings equal approximately the PTE tax amount multiplied by the member’s marginal federal tax rate. For someone in the 37% federal bracket, every $100,000 of PTE tax paid generates roughly $37,000 in federal savings. That’s money that was previously lost to the SALT cap.

One thing to watch: the entity’s deduction of the PTE tax reduces each member’s federal K-1 income. If a member is relying on that income for other federal calculations (like the qualified business income deduction under Section 199A), the lower K-1 income could reduce their QBI deduction. The interaction between PTE and 199A needs to be modeled for each entity. Sometimes the PTE benefit outweighs the lost QBI deduction. Sometimes it doesn’t.

Guaranteed Payments and Their Treatment

Guaranteed payments to partners get special handling under the PTE rules, and it’s an area where the FTB’s position has caused some confusion.

Guaranteed payments under IRC Section 707(c) are included in the partner’s qualified net income for PTE purposes. That means the entity can pay the 9.3% tax on guaranteed payments, and the partner gets the corresponding credit. This is actually a good result for partners who receive guaranteed payments — those amounts are often significant, and including them in the PTE base maximizes the federal deduction.

However, guaranteed payments for the use of capital (as opposed to services) follow different rules. The FTB has indicated that guaranteed payments for capital under Section 707(c) are also includable, but the sourcing rules can get complicated for multi-state partnerships. If a partner is performing services in California and receiving a guaranteed payment, it’s generally California-source income and belongs in the PTE calculation.

Multi-State Considerations: Non-Resident Members and Apportionment

California entities with members who live outside the state need to think carefully about how the PTE election interacts with multi-state filing obligations.

For non-resident members, only California-source income is included in the PTE calculation. If a partnership operates in multiple states and apportions its income, only the California-apportioned share of a non-resident member’s income gets included in the qualified net income on Form 3804. The non-resident member then claims the Form 3804-CR credit on their California non-resident return (Form 540NR).

Where this gets interesting is the other-state-tax-credit side. If a member lives in a state that allows a credit for taxes paid to other states, the PTE credit on Form 3804-CR may reduce the amount of California tax the member “paid” for purposes of claiming that credit in their home state. Some states have addressed this explicitly; others haven’t. New York, for example, has its own PTE regime, so a member of both a California and New York entity could be navigating two separate elections simultaneously.

Resident members of California include their entire distributive share in the PTE base — regardless of where the income was earned — because California taxes residents on worldwide income.

Common Mistakes and Planning Tips

Mistakes We See Repeatedly

• Missing the June 15 prepayment deadline. This kills the election for the entire year. Put it on the calendar the day you decide to elect.
• Forgetting that the election is irrevocable. Run the numbers before you file Form 3804. Once it’s filed, you’re committed for that tax year.
• Not modeling the 199A interaction. The PTE deduction lowers federal K-1 income, which can reduce the Section 199A qualified business income deduction. For some entities, particularly those in specified service trades, this tradeoff needs to be calculated carefully.
• Treating members with losses as negative numbers. Each member’s qualified net income floors at zero. You can’t net one member’s $50,000 loss against another member’s $200,000 gain for PTE purposes.
• Assuming all members must participate. The election requires consent from each qualified member whose income is included. A member can choose not to consent, and the entity calculates the PTE tax only on consenting members’ income.

Planning Tips

Run the election math every year. The benefit depends on the members’ federal tax brackets, their other SALT deductions, and whether they’re already at the $10,000 cap. For high-income California business owners, the answer is almost always yes — elect. But “almost always” isn’t “always.”

Consider the timing of income recognition. If the entity expects a particularly high-income year, the PTE election becomes more valuable because the federal deduction is worth more at higher income levels. Conversely, a low-income year might not justify the administrative cost and the 9.3% rate applied to income that would have been taxed at lower California brackets individually.

Coordinate with your business tax return preparer early. The June 15 prepayment means the decision point comes months before the entity return is due. Waiting until tax season to think about PTE is too late. If you also need to coordinate estimated tax payments at the individual level, get that conversation started early.

Real-World Example: Seeing the Numbers

Let’s walk through a concrete scenario. Suppose you have a two-member California LLC taxed as a partnership. Each member owns 50%. The LLC’s net income for 2025 is $800,000, meaning each member’s distributive share is $400,000.

Without the PTE Election

Each member reports $400,000 of pass-through income on their federal and California returns. On the federal return, they can deduct a maximum of $10,000 in state and local taxes (and that $10,000 has to cover property taxes and state income taxes combined). If either member is already paying $10,000 in property taxes, they get zero additional federal deduction for California income taxes paid.

Each member’s California tax on $400,000 of income is roughly $35,500 (at the top marginal rates). Federally, at the 37% bracket, the tax on $400,000 of pass-through income is approximately $148,000 per member. Total combined federal and state tax per member: about $183,500.

With the PTE Election

The LLC pays 9.3% on $800,000 of combined qualified net income: $74,400 in PTE tax. This payment is deductible on the federal partnership return. Each member’s federal K-1 income drops from $400,000 to $362,800 ($400,000 minus their $37,200 share of the PTE deduction).

Each member’s federal tax on $362,800 is approximately $134,236 (saving roughly $13,764 in federal taxes compared to the no-election scenario). On the California side, each member claims a $37,200 credit on Form 3804-CR, which offsets the California tax they’d otherwise owe on that income. The California result is essentially neutral.

The Bottom Line

Each member saves approximately $13,764 in federal taxes. For the two-member LLC, that’s $27,528 in total annual savings — just from making an election and filing two extra forms. Over five years, that’s more than $135,000 kept in the owners’ pockets instead of sent to the IRS. The math gets even more dramatic for entities with higher income or more members. For a broader look at how federal tax rates work, see our capital gains guide.

Sources & References

• California Franchise Tax Board — Pass-Through Entity Elective Tax
• FTB Form 3804 — Pass-Through Entity Elective Tax Calculation
• FTB Form 3804-CR — Pass-Through Entity Elective Tax Credit
• IRS Notice 2020-75 — Specified Income Tax Payment Reporting
• 26 U.S.C. §164 — Taxes (SALT deduction limitations)
• 26 U.S.C. §199A — Qualified Business Income Deduction
• 26 U.S.C. §707 — Transactions Between Partner and Partnership
• California AB 150 — Pass-Through Entity Elective Tax Act