Pass-Through Entity Tax (PTET): How Business Owners Can Legally Circumvent the $10,000 Federal SALT Cap

The Problem: The $10,000 Federal SALT Cap

Enacted under the Tax Cuts and Jobs Act of 2017, the federal limitation on State and Local Tax (SALT) deductions capped individual itemized deductions for state income, sales, and property taxes at $10,000 per year ($5,000 for married taxpayers filing separately).

For business owners and partners operating in high-tax jurisdictions—including California, New York, New Jersey, Illinois, Massachusetts, and Connecticut—this statutory restriction resulted in staggering amounts of double taxation, with tens or hundreds of thousands of dollars in state taxes becoming completely non-deductible on federal Form 1040 Schedule A.

The Solution: IRS Notice 2020-75 and the PTET Election

In November 2020, the Internal Revenue Service released historic guidance in IRS Notice 2020-75, announcing that the Department of the Treasury intends to issue proposed regulations confirming that state and local income taxes imposed on and paid by a partnership or S-corporation on its taxable income are allowable as a deduction by the partnership or S-corporation in computing its taxable income or loss for the taxable year.

This formal safe harbor created the foundation for state-level Pass-Through Entity Tax (PTET) legislation, which has now been enacted across more than 36 states.

How the PTET Mechanism Operates

1. Entity-Level Election: The operating S-Corporation (Form 1120-S) or Partnership (Form 1065) makes a timely statutory election with the state department of revenue to pay tax at the entity level on behalf of its eligible owners.
2. Above-the-Line Federal Deduction: The entity pays the calculated state tax and claims it as a direct business expense on Form 1120-S (Line 12) or Form 1065 (Line 14). This reduces the net ordinary business income flowing to owners on Schedule K-1.
3. State Tax Credit on Personal Return: The individual shareholder or partner receives a corresponding dollar-for-dollar tax credit on their individual state return, offsetting their personal state tax liability.

Critical Implementation Deadlines & Traps

While PTET offers massive financial benefits, strict adherence to state procedural guidelines is mandatory:

• Timely Election Windows: Most states require the annual PTET election to be executed on or before March 15 of the taxable year (or with the timely filed return). Missing this election window forfeits the tax savings for the entire year.
• Mandatory Quarterly Estimates: States mandate strict quarterly estimated payments under the entity's identification number. Paying from personal accounts can invalidate the election.
• Multi-State Resident Credit Interplay: When partners reside in different states than where the business operates, careful review of resident state credit statutes (e.g., California vs. New York reciprocity) is essential to avoid double state taxation.