California Pass-Through Entity Tax Deduction

California’s Pass-Through Entity Elective Tax (PTET) is the state’s workaround for the federal SALT deduction cap. It generally saves owners real federal tax dollars. But the rules for the mid-year prepayment have a structural flaw that hurts businesses with volatile income. If you had a great year in 2025 and expect a weaker 2026, the prepayment formula will force you to overpay California, and the state will not let that overpayment be designated as your next PTET prepayment. It gets refunded, or applied to other obligations like your LLC annual fee or S corporation estimates, only after your return is filed the following spring. That means your cash sits at the FTB for most of a year. Yuck.

How the Prepayment Works

By June 15 of each tax year, your entity must pay the greater of $1,000 or 50% of last year’s PTET liability. The remainder is due by the original return due date in March of the following year. The PTET rate is 9.3% of qualified net income. The prepayment is calculated by looking backward, not forward, which is the root of the problem.

Your example, in numbers, and yes, these are crazy exaggerated, but illustrative just the same.

Imagine $10M of business profit in 2025 and $2M expected in 2026:

• 2025 PTET liability at 9.3%: $930,000.
• Required June 15, 2026 prepayment (50% of 2025): $465,000.
• Actual 2026 PTET liability at 9.3% on $2M: $186,000.
• Overpayment: $279,000, refunded only after the 2026 return is filed in 2027.

The Franchise Tax Board has stated in its official guidance that a PTET overpayment cannot be applied as next year’s June 15 prepayment. It can be refunded, or applied to your LLC annual fee or S corporation estimates, but it cannot reduce next year’s PTET prepayment. The float sits with the state.

What Changed in 2026 (and what didn’t)

California passed SB 132 in June 2025, extending PTET through 2030. It also softened a brutal old rule. Before 2026, missing or underpaying the June 15 deadline by even $1 disqualified your entity from making the PTET election for the entire year. Starting in 2026, you can still make the election even if you underpay, but each owner’s PTET credit is reduced by 12.5% of the owner’s pro rata share of the unpaid amount. Good new and bad news, right?

This new flexibility gives you a real option: intentionally underpay on June 15 if you know your income will be lower this year, accept the 12.5% credit haircut on the shortfall, and keep your cash. Whether that comes out ahead is a real math question, not an automatic yes.

Doing the math on your example

Two paths, two costs:

• Path A (pay in full, accept refund): $279,000 trapped for about ten months. At a 6% cost of capital, that is roughly $14,000 of lost return. At 10%, roughly $23,000.
• Path B (intentionally underpay, accept the credit haircut): 12.5% of $279,000, or about $35,000 in lost owner credits.

On these numbers, Path A is cheaper. Path B becomes attractive at higher costs of capital (a venture-stage business with strong reinvestment opportunities), if cash flow is genuinely tight, or if other owner-level factors change the calculus. The point is that the decision needs to be modeled, not defaulted in either direction.

Pick your poison depending on your cost of capital.

A Cleaner Fix Was Proposed And Rejected (shocker)

Senator Glazer’s SB 1501 would have solved this more proportionally by combining interest at the federal underpayment rate (currently 6% for ordinary underpayments) with a smaller 10% credit reduction. The interest piece would scale with how long the shortfall actually sat unpaid, which is the economically correct way to penalize the timing mismatch. SB 1501 was held in Assembly Appropriations Committee on the suspense file in August 2024 and never advanced. The Legislature later adopted the simpler 12.5% flat credit reduction in SB 132 instead. We have not identified any successor bill specifically targeting this overpayment issue.

What You Should Do

1. Project your 2026 PTET liability by early May. If your projection is materially lower than 50% of your 2025 PTET, you have a planning decision to make.
2. Have us model both paths with your actual cost of capital and any cash flow constraints. Do not assume one is better.
3. For LLCs, ask us to apply any overpayment to the following year’s annual tax and fee. For S corporations, apply to next year’s estimates. This recovers a small slice of the trapped cash.

Bottom Line

California knows this rule punishes volatile businesses. The FTB documented the trap in its own guidance. The Legislature had a more proportional fix in front of it and chose not to pass it. The responsibility falls on you and your tax team to project your income early and model the two paths deliberately. If your 2026 looks meaningfully smaller than your 2025, please reach out before June 1 so we have time to run the numbers together.