The passage of the 2017 Tax Cuts and Jobs Act instituted a limit on the State and Local Tax (SALT) deduction of $10,000. As a workaround to receive more tax benefit for business owners in high tax states like California and New York whose deductions have been severely limited by this cap, many states have begun to implement pass through entity taxes (PTETs) as a tax planning workaround.
How do Pass Through Entity Taxes Work?
The pass through entity tax allows a business owner of a pass through entity such as an S corporation or partnership to pay state tax payments directly through the business as opposed to having those taxes flow through to the owners individual returns. By paying these state tax payments through the business it creates a federal tax deduction for the business owner that, as a business deduction, is not subject to the $10,000 SALT deduction limit. As it currently stands, 33 different states allow PTETs and the strategy was given the IRS’s blessing in IRS Notice 2020-75. The details of how PTETs work varies from state to state but in general the process is as follows:- Business owner makes a PTET election, subjecting the business to the state level taxes and paid at the entity level.
- The business owner receives a tax credit on their personal state taxes to offset up to 100% of the state taxes paid by the business. Some states offer a credit that is less than 100% meaning that some business income is effectively double-taxed.
- The state tax payment paid by the business is included as a deductible business expense on the business’s federal tax return, lowering its net income that is divided among each of its owners and passed through to their federal tax returns.
