Pass-through entity tax

What is the SALT cap and why does PTET exist?

The 2017 Tax Cuts and Jobs Act introduced a USD 10,000 cap on the federal deduction for state and local taxes (the SALT cap) under IRC §164(b)(6) for tax years 2018 through 2025. The cap materially reduces federal-deduction value for filers in high-tax states (California, New York, New Jersey, Connecticut, Massachusetts, Illinois, Hawaii, Oregon) where state income tax alone often exceeds USD 10,000. State responses focused on workaround mechanisms that would preserve the federal-deduction value. The Pass-Through Entity Tax (PTET) framework — first enacted by Connecticut in 2018, adopted by approximately 36 states by 2024 — is the principal workaround. The mechanic: a partnership or S-corp elects to pay state income tax at the entity level on its taxable income; the federal deduction for state income tax taken at entity level is unrestricted by the SALT cap (which applies only to the individual-level deduction); pass-through owners receive a state-tax credit for the entity-paid tax against their state-individual-level tax. Net effect: full federal deduction preserved at entity level + state tax fully credited at owner level.

How does the IRS bless the PTET framework?

IRS Notice 2020-75 (issued November 2020) provided substantive blessing for PTET regimes — confirming that state and local income taxes paid by a partnership or S corporation are deductible by the entity for federal tax purposes, regardless of the entity-level vs. individual-level character of the underlying state-tax-payment substance. The Notice's safe-harbour position eliminated the principal uncertainty about whether IRS would re-characterise PTET payments as constructive distributions plus individual-level state-tax payments (which would be subject to the SALT cap). The Notice does not bless every state's specific PTET design — implementation details vary materially — but provides the core blessing that allows the framework to operate. Subsequent IRS guidance has continued to refine the boundaries; practitioners should monitor for further IRS positions before assuming a particular state's PTET design qualifies under §164(b)(6) safe harbour.

What are the principal PTET design variations?

The ~36 PTET states have material design variation across several axes. Election mechanics: most states (California, New York, New Jersey, etc.) operate annual election with deadline alignment to the partnership's year-end; some require pre-election by the prior tax-year-end. Eligible entities: most states limit PTET to partnerships and S corporations; a few include disregarded entities owned by individuals. Owner-credit mechanism: most states provide a non-refundable credit against the owner's state individual-income-tax liability; some states refund excess credit; a few states (Wisconsin pre-2024) operated as a deduction rather than credit. Income-base computation: most states tax the partnership/S-corp income allocable to electing owners; some states tax all entity income. Tax-rate election: most states use the highest individual-marginal-rate; some states allow election among multiple rates. The cumulative effect: PTET design is among the most state-specific areas of US tax practice, with substantial inter-state planning complexity for multi-state pass-through structures.

What planning considerations apply?

Common PTET planning conversations practitioners have with clients: (i) annual entity-level election timing — most states require entity-level election before year-end; missing the deadline forfeits the workaround for that year; (ii) multi-state apportionment — pass-through entities operating in multiple states require coordinated PTET election across each state's framework, with the entity-level state-tax-payment apportioned by state-source rules; (iii) owner-mix sensitivity — PTET typically benefits owners who face SALT-cap binding; owners who don't face the cap (low-income, low-state-tax) get neutral or marginally negative treatment; (iv) federal-deduction-value computation — accurately modelling federal benefit requires entity-level + owner-level + state-credit-utilisation analysis; (v) TCJA sunset interaction — the SALT cap is scheduled to sunset 31 December 2025; if Congress allows the cap to expire, PTET workarounds become economically irrelevant for tax years from 2026 onwards. Substantial uncertainty about post-2025 SALT-cap status means PTET planning is materially affected by the political-and-legislative context.

How do other major jurisdictions handle pass-through-entity taxation?

Most non-US major jurisdictions do not operate analogous PTET frameworks because their corporate-individual integration mechanisms differ structurally. UK: partnership taxation operates entirely at partner level with no entity-level tax; S-corp-equivalent does not exist in UK framework. Canada: partnerships are tax-transparent at federal level; provincial taxation similarly transparent. CCPC (Canadian-Controlled Private Corporation) operates with corporate-individual integration via the dividend gross-up + dividend tax credit mechanism rather than pass-through. Australia: partnerships are tax-transparent; Australian dividend imputation handles the corporate-individual integration question through a different mechanism. Germany: GmbH operates as full corporate taxpayer; OHG/KG partnerships are tax-transparent with no entity-level tax. France: SAS/SARL fully corporate; SCI partnership-style transparent. Singapore: one-tier corporate dividend exemption eliminates the integration question that PTET addresses. Hong Kong: territorial framework eliminates the same. The PTET framework is a US-specific innovation responding to a US-specific federal-deduction-cap problem; the closest international parallel is corporate-individual-integration mechanisms (imputation, gross-up-and-credit, partial-inclusion) that operate at different points in the income flow.