Two California tax proposals could be devastating for credit funds and their investors

California is facing a budget deficit of about $12 billion in fiscal year 2026. Gov. Gavin Newsom’s (D) 2025-26 May Revision budget summary includes new spending cuts but does not include new tax proposals compared to the January version. Recall that the January budget proposal included a shift to single-sales-factor apportionment for financial institutions, which is projected to result in $330 million in tax revenue in 2026.

Additionally, in a June 5th statement to Tax Notes which is mentioned in today’s article California Lawmakers Float Corporate Tax Increase Proposals, Assembly Member Alex Lee (D) has floated the idea of repealing the California water’s edge election, which is projected to result in $3 - $4 billion in tax revenue annually.

Both tax proposals, if enacted into law, could be devastating for certain private credit funds and their investors. The potential adverse impact and planning opportunities are summarized below.

Proposed change to single-sales-factor apportionment formula for Financial Institutions

Adverse impact:

Credit funds that file as financial institutions in California, which perform loan origination activities outside of the state, may see their California apportionment percentage and tax liability double as a result of the state’s change to a single-sales-factor apportionment formula.  

Planning opportunities:

There may be an opportunity to revisit the sales factor sourcing under the Financial Institution apportionment rules, if all that a credit fund is left with is a single sales factor to apportion its income to California.

Asset-based and infrastructure lenders which plan to make multiple collateralized loans to the same borrower may want to consider combining and cross-collateralizing the loans into a single loan/collateral agreement, so that less than 50% of the fair market value (FMV) of cross-collateral is located in California. In that case the interest income on the loan would be sourced to the commercial domicile of the borrower (potentially outside of California) and not pro-rata based on the FMV of collateral in California under the state’s Financial Institution apportionment rules.  

Proposed repeal of the California water’s-edge election

Adverse impact:

Stand-alone corporations or unitary group of corporations with nexus in the state which were previously taxed on income that is effectively connected with a U.S. trade or business (ECI) only from state sources could also become subject to tax upon fixed, determinable, annual, or periodical (FDAP) income from state sources, if the water’s edge election is repealed.  

Planning opportunities:

There may be an opportunity to revisit the activities that generate ECI (e.g., direct lending) or FDAP income (e.g., secondary market purchases), as well as the entities engaged in those activities. Ideally, the FDAP income-generating activities should be isolated into a separate entity which may be eligible for the state’s ‘purchased loan exemption’ which is afforded to certain foreign lending institutions pursuant to Cal. Corp. Code § 191(d).

The management and execution of direct lending and secondary market purchases may need to be separated into different teams at the management company (or external asset manager), so that commonly controlled entities engaged in either strategy would not be considered ‘unitary’ and combinable, which could subject the FDAP income from secondary market purchases to California corporate income taxation on a combined basis.

For more information or if you would like to discuss, please contact us at info@creditfundadvisors.com or phone 646-551-3050. 

House Bill H.R. 1 Advances to Senate

Update on the SALT Cap and PTET Deduction as of May 22, 2025

House bill H.R. 1, which was approved by the House and advanced to the Senate earlier today, May 22, 2025, includes the following Amendments to the “SALT cap” (i.e., section 112018, Limitation on Individual Deductions for Certain State and Local Taxes, etc.), among other provisions, contained in the original bill which was advanced by the Ways & Means Committee on May 14, 2025:

• Increased the limit on the federal deduction for state and local taxes to $40,000 per household ($20,000 for married taxpayers filing separately) starting in 2025.

• Adopted a threshold of $500,000 per household ($250,000 for married taxpayers filing separately) on modified adjusted gross income (MAGI) above which the federal deduction is phased out starting in 2025.

• For tax years between 2026 and 2033, the $40,000 and $500,000 SALT cap and threshold amounts are increased by 1% per year. For tax years after 2033, these amounts remain fixed at the 2033 level.

It should be noted that the effective date for these provisions was accelerated from 2026 originally to 2025 in the approved House budget.

There was a technical correction made to the original bill allowing a deduction for state pass-through entity taxes (PTETs) for section 199A qualified trades or businesses (i.e., non-SSTBs). Specifically, on page 971, line 12, the phrase “or (4)(A)(ii)” was inserted after “paragraph (3)(A)” of section 112018(b)(5) which defines “substitute payments.” As a result of this technical correction, the definition of this term in the approved House bill excludes an “excepted tax” as defined in paragraph (4)(A)(ii) of this section as “any tax as described in section 164(a)(3) which is paid or accrued by a qualifying entity with respect to carrying on a qualified trade or business (as defined in section 199A(d) without regard to section 199(A)(b)(3).” We believe that this technical correction reflects the legislative intent of the House to allow the PTET deduction for pass-through entities that are section 199A qualified trades or businesses (i.e., non-SSTBs) as per the Joint Committee on Taxation’s description (see page 311) of this provision.

Two days earlier, on May 20, 2025, the AICPA had submitted AICPA Comment Letter - One Big Beautiful Bill Act | Advocacy | AICPA & CIMA to the Ways & Means Committee in which it commented on various tax proposals in the bill. In this letter, the AICPA urged Congress to retain the PTET deduction for all pass-through entities, not just those that are section 199A qualified trades or businesses (i.e., non-SSTBs). It is yet to be seen whether the Senate would make any changes to the bill equalizing the SALT cap workarounds for all pass-through entities, including those that are SSTBs in addition to those that are non-SSTBs. We will continue to track the bill’s progress and update you on further developments.

Superseded Post from May 21, 2025 (read below)

According to CBS News,[1] the latest reported House GOP proposal is to allow a $40,000 SALT cap for families with up to $500,000 in income, after which the benefit would be phased out, effective for 2026.

After 2017, over 35 states and one locality have enacted elective pass-through entity taxes (PTETs) that serve as workarounds to the current SALT cap of $10,000 which expires at the end of 2025.[2] These PTETs allow the owners of electing pass-through entities to deduct state and local taxes as business expenses on the entity’s federal return without being subject to the current SALT cap in accordance with IRS Notice # 2020-75.[3]

The Ways and Means bill that was advanced on May 16, 2025, as currently written, appears to bar the SALT cap workarounds for all pass-through entities, regardless of whether they operate a trade or business that qualifies for the section 199A deduction. [4] For further details, please read Ways and Means Bill Curtails SALT Cap Workarounds for All Passthrough Entities – The Tax Law Center. [5]

There may be gaps in the plain text bill that allow SALT cap workarounds, which are not immediately obvious. Moreover, the bill is subject to change as it passes the House and moves to the Senate. There is likely to be a negotiation process to reconcile the two versions of the bill, before it can be sent to the president for his signature. So, it is too early to conclude whether the SALT cap workarounds will survive after 2025. We will keep you updated on this as the bill progresses.

Footnotes:

[1] Jennifer McLogan, Congress appears poised to raise SALT cap as part of Trump tax bill. Here’s the latest. (May 21, 2025, at 6:20 PM EDT), https://www.cbsnews.com/newyork/news/salt-cap-tentative-deal-president-trump-budget-proposal/

[2] Brian Myers and Eileen Reichenberg Sherr, Recent Developments in states’ PTETs, The Tax Adviser (September 1, 2024)

[3] Id.

[4] Miles Johnson and Michael Kaercher of NYU Law’s “The Tax Law Center” at https://taxlawcenter.org/blog/ways-and-means-bill-curtails-salt-cap-workarounds-for-all-passthrough-entitie (last visited May 21, 2025 at 6 pm ET)

[5] Id.

Overview of the FY 26 NYC Executive Budget

The Executive Budget

On May 1, 2025, Mayor Eric Adams released New York City’s balanced $115.1 billion FY 26 Executive Budget, with projected gaps of $4.6 billion in FY 27; $5.8 billion in FY 28, and $5.7 billion in FY 29. Following that, City Charter Section 1515 gives the mayor discretion to change the FY 26 estimates for all revenues (including federal and state grants) up to May 25, 2025, in a communication to the City Council. Subsequently, the FY 26 revenue estimate can be amended with a message of fiscal necessity to the Council delineating the reasons for the change. Through May and June, the Council and the Mayor negotiate adjustments to the Executive Budget, resulting in an agreement known as the Adopted Budget. This agreement must be reached before July 1, the beginning of the next fiscal year.

It should be noted that the Executive Budget, which Mayor Adams released earlier this month, is predicated on economic conditions as well as federal fiscal and trade policy known prior to April 2025. [1] The unprecedented federal trade policy announced in April 2025 and the subsequent impact on financial markets poses a potential impact to the city’s economy as well as its tax base. Therefore, the outlook may be updated in the upcoming Adopted Budget.

Revenue Sources

New York City’s budget is funded through a mix of local taxes, non-tax revenue, and state and federal grants. Non-tax revenue comes from sources like permits, licenses, and fees. State and federal categorical grants provide additional funding for specific programs and services. The budget’s local tax revenue sources include the following:

(i)     Property tax;

(ii)    Personal Income Tax;

(iii)   Business income taxes, which include taxes on both corporations and unincorporated businesses;

(iv)   Sales tax; and

(v)   Real estate transaction taxes, which include both the Real Property Transfer Tax and the Mortgage Recording Tax.

Personal and business income tax revenues are sensitive to both economic and financial market downturns. Lost jobs and lower bonuses or incentive pay result in lower taxable incomes. Meanwhile, lowered capital gains from asset sales and diminished business income for sole proprietors, partnerships, and other pass-through entities, further erode income tax collections. Declines in the financial sector’s profitability have a disproportionate impact on the city’s business income tax collections, due to the significant share of the financial sector in the city’s economy.

Sales tax and real estate transaction taxes fall because of declining incomes from wages, capital gains, and business income. Additionally, investment in commercial real estate is dependent on overall business conditions, including policy uncertainty, and asset prices.

Chart 1 below shows the break-out of business income tax collection by entity type, including flow-through entities and corporations.

Chart 1: Business income tax liability by entity type ($ billion)

Business Income Taxes

In recent years, the growth of city taxes on business income has outpaced the growth of other local tax revenue sources. Since FY 19, business income taxes (inclusive of tax audits) have increased by more than 50%, whereas all other tax revenues combined grew by 17%. In FY 24, business income taxes represented 14.1% of all city tax revenues, 3 percentage points higher than in FY 19 and the highest share since FY 13.

New York City has a complex system of business income taxes, which are administered by the city’s Department of Finance (DOF) and include the following:

(i)   Business Corporation Tax (BCT) which applies to C-corporations;

(ii)  Banking Corporation Tax (BTX) which applies to banks that are also S-corporations;

(iii) General Corporation Tax (GCT) which applies to S-corporations;

(iv) Unincorporated Business Tax (UBT) which applies to sole proprietors (IRS Schedule C businesses) and unincorporated entities (partnerships and LLCs); and

(v)   Pass-Through Entity Tax (PTET) which is an optional tax on pass-through entities (specifically, S-corporations and partnerships) created in 2022 to circumvent the $10,000 cap on the state and local tax deduction from federal taxable income for individuals.

Chart 2 below shows the combined BCT, BTX, and GCT revenues for FY 2000 through FY 2024.

Chart 2: BCT, BTX, and GCT Revenues ($ billion)

Chart 3 below shows the UBT revenues for FY 2000 through FY 2024.

Chart 3: UBT Revenues ($ billion)

Impact of US Policy Changes

According to US Treasury Secretary Scott Bessent, tariffs, tax cuts, and deregulation are the “core components” of President’s Trumps economic agenda. [3] These three components, which are creating short-term turbulence, are supposed to work together to drive long-term investment and growth to the US economy. The Treasury chief said that the US markets are “anti-fragile” and well equipped to weather any short-term turbulence, citing the rebound from the Great Depression, two World Wars, the September 11 attacks, the 2008 – 2009 global financial crisis, and the COVID-19 pandemic.

As noted in the New York City Comptroller’s report entitled “Taking Trump’s Tariffs Seriously: The Fiscal and Economic Impact for NYC,” [4] tariffs are expected to have an indirect impact on the city’s business income taxes through their impact on GDP, consumption, and overall profit margins. The city’s economy is unlikely to benefit from onshoring of manufacturing activities or to be hurt directly by retaliatory tariffs, because exports are not sourced to New York City. Tariff-induced price increases may temporarily help sales tax collections, but declining consumer spending as a result of reduced employment and wage growth, combined with lower demand for goods due to higher prices, could have a stronger impact and reduce sales tax collections.

Federal tax policy will be a major focus of attention in 2025, mainly due to the extension of expiring individual tax provisions. At this time, proposals concerning the corporation tax appear to have a limited impact on the city’s business income taxes.

Deregulation could impact the financial and technology sectors through lower capital requirements and a wave of mergers and acquisitions and initial public offerings. Reports from recently released 2024 Q4 earnings of large banks signal high expectations for 2025, including for dividends and buybacks. If these expectations were to be realized, there would also be positive repercussions on personal income taxes.

It is worth noting that this is not a full evaluation of President Trump Administration’s economic policies. The slashing of federal government capacity and funding impacts the state and city budgets, the private sector, health and education institutions, and the providers of health and social services in ways that are not directly captured in this analysis. Immigration policies can drive population losses in New York City and could remove tens of thousands of workers from the labor market. The federal budget is also a source of uncertainty as the House and the Senate have just started the committee work that will lead to a final agreement.

Similar to families and businesses, the city is facing great uncertainty as it approaches the final stages of its budget process for FY 26. The Comptroller’s Office estimates suggest that the impacts of a recession on tax revenues, while possibly less severe than in the past, could be significant. As tax revenues for the rest of FY 25 appear to be on track to exceed budget expectations, the city should not waste the opportunity to deposit resources in its “rainy-day” fund to shore up finances in FY 26 and beyond. In addition, as previously proposed in the Comptroller’s report on the city’s Preliminary Budget, $1,0 billion should be added to the city’s general reserve fund in FY 26, to help protect New Yorkers from the broader fiscal uncertainties stemming from President Trump Administration’s funding cuts and immigration policies.

Sources:

[1] “Mayor Adams Releases “Best Budget Ever,” City of New York, Office of the Mayor / News, May 1, 2025.

[2] The Budget Process, New York City Council at https://council.nyc.gov/budget/process

[3] “Trump's tariffs, tax cuts, deregulation will drive US growth, investment, Bessent says” by David Lawder; Reuters, May 5, 2025.

[4] “Taking Trump’s Tariffs Seriously: The Fiscal and Economic Impact for NYC,” Office of the New York City Comptroller Brad Lander, April 16, 2025.