Partnership v. Disregarded entity re: Cal pass- thru entity new tax election

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Maria Ku

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Jul 26, 2021, 1:38:22 PMJul 26
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HW have filed 2 Sch Cs for 20 years for their professional-services business (a “disregarded entity” in Cal, a community-property state).
The business is small enough that none of the assets (just some minor home office equipment) are held in the name of the partnership – all owned as community-property by HW.
No separate bank account exists for the “disregarded” entity (partnership expenses are minimal and paid from the joint (personal) bank account and supported by “meticulous” records). W is providing professional services (and takes the home-office deduction); H does everything else (all the IT & clerical).
Now that California enacted its pass- through entity tax election (Tax Alert : https://www2.deloitte.com/content/dam/Deloitte/us/Documents/Tax/us-tax-mta-california-enacts-pass-through-entity-tax-election.pdf), they consider fining a general-partnership 1065/Cal 565 to avail themselves of the 9.3% business state-tax deduction. (Their whole 1065 would have one line for ordinary income = self-employment income, and split 50/50 on the K-1s, & shown as all distributed to them every year, so no capital-account basis. The partnership profit & assets are small enough that most of the Schedules (L, Ms) are not required to be filled out.)
My questions:

1. What exactly is the practical meaning of this statement in Rev Proc 2002-69 “A change in reporting position [b/w a “disregarded entity” v. a partnership] will be treated for federal tax purposes as a conversion of the entity”?

2. Could they go back to a “disregarded entity” in the future if for some reason they decide that partnership reporting is too cumbersome to justify the resulting tax savings?

3. Would it raise any flags if they’d suddenly start filing a 1065 (& a Cal 565) as a GP, & their prior Sch Cs would suddenly become Sch Es?

4. Could one even deduct a home-office on a Sch E (for a “genera” partner)? If not, should that K-1 (1065) income go to W’s Sch C, not Sch E?

5. Would there be any problem b/c assets or a bank account are not formally owned by the partnership proper?

Thank you for your insights. I will really appreciate your advice,

MK

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Stuart O. Bronstein

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Jul 26, 2021, 4:48:33 PMJul 26
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I haven't read the legislation. But it seems to me that this is a
non-problem. It's temporary and can be changed every year. And it
only applies to California taxation. So federal taxation shouldn't
be changed at all. It's still a pass-through entity which can elect
(for state income tax purposes) to be taxed at a flat rate of 9.3%,
or be taxed in the normal way.

I don't see how this has anything to do with federal tax.

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Stu
http://DownToEarthLawyer.com

Maria Ku

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Jul 26, 2021, 5:58:37 PMJul 26
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Federal taxation is the whole reason for this provision. With AB 150, partnership's share of Cal state income tax will be treated as a tax imposed on the business (p'ship), reduce ordinary income on partners' K-1s, and thus reduce taxable income, whereas still allowing up to $10k of individual's (couple's) other Cal state income tax as a Sch A deduction.

AB 150 does not change one's state tax liability, just the manner of payment, but allows for deductibility of the state income tax imposed on partnerships, in addition to the $10k Sch A allowance.
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