Pass Through Entity Taxes with Higher SALT Deduction
Deductibility of Pass-Through Entity Taxes with $40,000 per year SALT tax cap
BACKGROUND:
When states like California, New Jersey, and New York introduced Pass-Through Entity (PTE) tax elections—for example the PTE, BAIT, and PTET—many business owners asked the same question: Can these payments be deducted for federal purposes? The answer was yes. The IRS confirmed this in Notice 2020-75, clarifying that state income taxes paid by a partnership or S corporation under an entity-level election are deductible by the entity when calculating its taxable income. Under the notice, these “specified income tax payments” qualify as ordinary and necessary business expenses under IRC §164(a). That means the deduction is taken at the business level—reducing the income that passes through to owners on their Schedule K-1—even if the owners later receive a credit or adjustment on their personal state returns. This ruling effectively allows pass-through businesses to bypass the $10,000 federal SALT deduction cap. By paying and deducting the tax at the entity level, owners retain the benefit of a full state tax credit while enjoying an additional federal deduction—making these programs one of the most valuable post-TCJA planning tools for multi-owner businesses.
Is this still useful with the SALT tax cap increase?
Sometimes. Consider the STANDARD deduction increase. Now consider a business owner, let’s name them Adam, is single and does not own his primary residence. He rents and has little to no itemized deductions. Also imagine a scenario where Adam owns an S Corp that has revenue of $220,000 and income. Adam pays himself $65,000 in W2 wages and $65,000 via box 1 of the 1120 K1. In this scenario, it is plausible that Adam will take the STANDARD deduction. Consider that the Pass Through Entity Tax LOWERS Adam’s K1 income, therefore still reducing his taxes.
In situations where the standard deduction is NOT taken, and the SALT deduction on the owner’s personal 1040 tax return is less than $20,000 ($40,000 if married filing jointly)… then the pass through entity tax is moot and a waste of time and effort. But in Adam’s situation, and in situations where one’s SALT deduction is still capped, the pass through entity workaround is still useful.
Also, Adam were to have an AMAZING year with 2 million in revenue as a “one person shop”, the PTE would be still be beneficial since the state income tax still exceeds the SALT cap limit.
