Using the Pass-Through Entity Tax (PTET) to work around the state tax deduction cap
The Pass-Through Entity Tax (PTET) is a state-level tax innovation introduced in response to the $10,000 federal limitation on state and local tax (SALT) deductions associated with the 2017 Trump tax legislation. For pass-through entities such as partnerships and S corporations, the PTET is a powerful tax planning tool that allows business owners to actually deduct the state taxes they pay, offering a workaround to the $10,000 federal SALT deduction cap.
Some history on the SALT deduction cap
Prior to the 2017 Trump tax legislation taking effect in tax year 2018, state taxes paid were fully deductible as itemized deductions on Schedule A. For high-income taxpayers in high-tax states such as California, New York, and Oregon, this deduction provided significant tax relief, given that top tax brackets in those states can exceed 10%.
However, the 2017 Trump tax legislation significantly changed federal tax policy - one of its major provisions being a cap of the SALT deduction at $10,000 per year for individual taxpayers. For high earners in high-tax states, state taxes alone could be more than triple that figure, meaning that once the SALT cap took effect in 2018, many folks found themselves with a tax liability several thousand dollars higher than the prior year.
So, what is the PTET, and how does it help avoid the SALT cap?
The PTET is an elective tax that certain states allow pass-through entities (partnerships, S-corps) to elect into. Essentially, electing into the PTET allows for the pass-through entity to pay state tax on its net income on behalf of the owner(s) - this generates a deductible expense for federal purposes (lowering federal tax due), while the PTET payment amount is given back to the business owner(s) on the state personal return as a credit. The net effect of the election is to lower federal tax due while keeping the overall state tax liability the same.
Here’s more specific insight on the exact mechanics:
The entity elects into the state PTET (if the state offers an election, which most do)
The entity pays income tax on its taxable income at the state PTET rate (varies by state)
The entity deducts the state taxes paid as a business expense on its federal return, reducing federal taxable income and the associated tax liability
The owners receive a state-level tax credit in the amount of the PTET payment to avoid double taxation
The result? The business owners effectively receive the full benefit of the SALT deduction. Depending on their own individual situation and the amount of other itemized deductions they may be able to claim, some taxpayers can even double dip by taking the standard deduction and still getting the benefit of the PTET election.
How much savings can a PTET election yield?
Savings generated by a PTET election depend on a variety of factors, such as the business’ net income, the state PTET rate, etc. However, for illustrative purposes, let’s assume that we have a single business owner in California who makes approximately $375,000 in taxable income, and will thus be taxed at the 35% federal tax bracket. Of that $375,000 in taxable income, let’s assume that $250,000 of that income is net income generated by the taxpayer’s business.
California has a PTET rate of 9.3%, meaning that this taxpayer will end up paying a total PTE tax of $23,250. This new PTET payment of $23,250 will reduce the taxpayer’s federal taxable income by that same $23,250, which, at the 35% tax bracket, will generate $8,137.50 in federal tax savings. Granted, this taxpayer happens to have a tax situation that is particularly PTET-friendly, given the high net business income and the fact that CA has a high PTET rate, but even so, this example illustrates just how powerful a PTET election can be under the right circumstances.
Important considerations before making a PTET election
As I always tell clients, every tax strategy has pros and cons - there is no “magic bullet” that can suddenly reduce tax without a corresponding drawback in some other respect. One great example of this principle is retirement account contributions - yes, there is a current year tax deferral associated with the contributions, but this comes at the price of locking up your funds until retirement. What is great about a PTET election is the fact that under the right circumstances, the pros outweigh the cons to a greater extent than pretty much other tax planning strategy out there, but there are still some considerations to be made, as outlined below:
Cash flow impact: While a PTET election can generate tax savings on an overall basis, many states often require significant upfront PTET payments as a condition of electing in. California, for example, requires 50% of the prior year PTET tax to be paid by June 15, which can be a significant sum.
Refundability of credits: While many states offer a refundable PTET credit, not every state does. California’s PTET credit, for example, is non-refundable, meaning if the credit exceeds your total tax, you will not be refunded the balance. CA does allow taxpayers to carry the credit forward five years, but in some cases (such as when a taxpayer moves out of state), there is a risk of losing some of the credit. As such, it’s important to consider state-level regulations on the refundability of the credit as part of an overall analysis.
Timing of election: Certain states have a deadline for electing in. California, for instance, requires entities to make a 1st-half PTET payment by 6/15 - entities which do not do so, with a few exceptions, lose the ability to elect in.
Additional tax compliance complexity: PTET elections do complicate tax return preparation, especially for tiered entities, entities with multiple partners, and entities with multi-state tax considerations. As such, it’s important to ensure that the savings associated with a PTET election outweigh additional tax filing and compliance costs.
Final notes
It is important to keep in mind that the guidance above may become obsolete depending on the changes to the tax code that may arise as a result of the “Big, Beautiful Bill” currently making its way through Congress. That being said, at least for tax year 2025, PTET elections remain a great tax planning tool. Importantly, PTET elections are made on a year-by-year basis, meaning a PTET election in 2025 won’t hurt you in future years if the Big, Beautiful Bill significantly changes the tax planning landscape in this regard.
Since the viability of a PTET election varies depending on each individual tax situation, it’s important to discuss a potential election with a CPA and have them run the numbers for your particular situation. There are so many factors that affect whether a PTET election is the right decision that there is no one-size-fits-all answer.
At Doug Johnson CPA, we’re experienced when it comes to working with small business owners and advising them on the most tax-advantaged structure for their businesses. For a free consultation to discuss your tax situation and whether you could save on taxes by making an PTET election, reach out anytime and we’ll get some time on the calendar to chat!