Overview
The SALT deduction cap limits federal itemized deductions for state and local taxes, including state income taxes, property taxes, and personal property taxes.
With the cap now increased to $40,000, more taxpayers can deduct state and local taxes, but PTE elections remain a powerful strategy for high-income owners, non-itemizers, and pass-through businesses seeking federal tax efficiency. The IRS continues to recognize entity-level PTE deductions under Notice 2020-75.
What Is a Pass-Through Entity (PTE) Tax?
A PTE tax allows a partnership, multi-member LLC, or S corporation to pay state income taxes at the entity level rather than on individual owners’ returns.
This transforms state tax payments from an itemized deduction into a business expense, bypassing the federal SALT cap and reducing taxable income at the federal level.
Eligible Entities
- Partnerships
- Multi-member LLCs taxed as partnerships
- S corporations
Not eligible: Sole proprietors and single-member LLCs taxed as disregarded entities.
Why PTE Taxes Work
The SALT deduction cap applies only to individual itemized deductions. By electing a PTE tax:
- The entity deducts state income taxes as a business expense.
- Owners report reduced distributable income on their federal Schedule K-1.
- Non-itemizers receive an above-the-line benefit, reducing adjusted gross income.
PTE elections can also reduce self-employment tax exposure for LLC members and partners.
How States Handle PTE Elections
States generally follow one of two approaches:
Owner Exclusion States
Owners exclude their share of PTE income from personal state tax returns because the entity has already paid the tax.
Examples: Arkansas, Colorado, Georgia, Louisiana, Mississippi, New Mexico, North Carolina, Oklahoma, South Carolina, Wisconsin.
Owner Credit States
Owners report the income but take a state tax credit for the PTE tax paid by the entity.
Examples: Arizona, California, Idaho, Illinois, Kansas, Maryland, Massachusetts, Michigan, Minnesota, New Jersey, New York, Oregon, Rhode Island, Virginia, Utah.
State rules vary and may include sunset clauses or conditions tied to federal SALT law.
Example: California LLC
ABC, LLC has two members and $400,000 in net income.
Without PTE Tax:
- Each member reports $200,000 income.
- California income tax: $18,600 each (example 9.3% rate).
- Federal tax: $48,000 each (example 24% rate).
- Federal SALT deduction limited to $40,000 for itemized deductions.
With PTE Election:
- LLC pays $37,200 to California at the entity level.
- Deductible as a business expense, reducing federal taxable income.
- Each member reports $181,400 on federal return, saving federal tax.
- State credit offsets individual California tax, resulting in zero state tax on LLC income.
QBI Consideration:
- PTE tax reduces Qualified Business Income (QBI) dollar-for-dollar.
- Example: $37,200 PTE tax × 20% = $7,440 reduction in Section 199A deduction.
- Federal tax increase due to QBI reduction is offset by savings from the PTE deduction.
IRS Guidance
Notice 2020-75 confirms:
- State income taxes paid by a PTE are deductible at the entity level.
- These payments can be reflected in non-separately stated income on owners’ Schedule K-1s.
- No separate federal reporting is required for owners, but state rules must still be followed.
Advantages of PTE Elections
- Bypass the federal SALT deduction cap.
- Provide above-the-line benefit to non-itemizers.
- Reduce federal taxable income and self-employment taxes.
- Improve after-tax cash flow and state tax planning.
Considerations
- Reduces QBI deduction under Section 199A.
- State rules vary and may have deadlines, carry-forward limits, or sunset clauses.
- High-income taxpayers should model results carefully to determine net benefit.
Key Takeaways
- PTE elections remain valid and beneficial for many pass-through owners.
- The $40,000 SALT cap increases itemized deductions but does not eliminate PTE benefits.
- IRS Notice 2020-75 governs federal entity-level deductions.
- Always verify current state PTE rules, including credits, exclusions, and eligibility.
- Proper planning can maximize federal and state tax efficiency.
Frequently Asked Questions
Is the PTE tax worthwhile under the new SALT cap?
Yes, particularly for non-itemizers and owners with high state tax exposure.
Which entities can elect PTE taxes?
Partnerships, multi-member LLCs taxed as partnerships, and S corporations. Single-member LLCs and sole proprietors are not eligible.
Does the IRS approve PTE deductions?
Yes. Notice 2020-75 allows the deduction at the entity level and clarifies reporting on Schedule K-1s.
Do all states offer a PTE election?
No. More than 30 states offer it, but rules vary. Some have sunset clauses or tie eligibility to the federal SALT law.
Please get in touch with our office if you have questions about PTE election and other PTE-related matters.