Pass-Through Entity Tax Election and the SALT Cap (2026)

The state and local tax deduction cap under IRC Sec. 164(b)(6) limits an individual's deduction for state income and property taxes. For a business owner paying $90,000 of state income tax, most of that deduction is lost.

The pass-through entity tax election is the workaround, and unlike most workarounds it has explicit IRS blessing. Notice 2020-75 confirmed that state income taxes paid by a partnership or S corporation are deductible by the entity in computing non-separately stated income, and are not subject to the individual cap.

More than thirty states have enacted some version of it. The savings are real, and so are the traps.

How It Works

The state enacts an elective entity-level income tax on pass-through entities. The entity pays state tax on its income, deducts that payment as a business expense, and passes through reduced income to owners.

Owners then receive either a credit against their state tax liability or an exclusion of the income from their state return, depending on the state's design.

The result is that the state tax is paid with pre-federal-tax dollars. A partner allocated $900,000 of income in a state with a 6% rate sees the entity pay $54,000 of state tax, reducing the federal K-1 income to $846,000. That $54,000 is fully deductible federally rather than being capped.

At a 37% federal rate, the federal benefit is approximately $20,000 on that one owner. Across a four-partner firm, it can approach $80,000 annually.

Which Entities Qualify

The election is available to partnerships and S corporations. Sole proprietorships and single-member LLCs treated as disregarded entities generally do not qualify, because there is no entity separate from the individual for this purpose.

That is a meaningful planning point. A single-member LLC owner in a PTET state may benefit from adding a second member, converting the entity to a partnership, or electing S corporation status, purely to access the election.

The second member must be genuine. A nominal interest with no capital and no economic participation invites challenge on multiple fronts.

C corporations do not need the workaround, since they deduct state taxes at the entity level already.

Where It Backfires

The election is not universally beneficial, and several fact patterns produce a worse outcome.

Owners who do not itemize. If an owner takes the standard deduction, the SALT cap was not costing them anything, and the entity-level tax simply shifts timing without benefit. Some state designs can leave them worse off.

Nonresident owners. An owner living in a state that does not allow a credit for another state's PTET can end up double taxed. Several states have addressed this and several have not. For a partnership with owners in multiple states, this must be modeled owner by owner.

Owners with state credits or attributes. An owner already using state credits that offset their liability may find the entity-level payment redundant.

Owners in a loss year. The entity-level tax is generally computed on entity income, and an owner with offsetting losses elsewhere may prepay tax they would not have owed.

Cash flow timing. The entity must actually pay the tax to deduct it, and most states require estimated payments during the year. An entity that distributes all cash to owners may need to change its distribution policy.

Election Mechanics Vary Widely

There is no uniform design. Some states require an annual election, some make it binding for multiple years, and some require it to be made by a specific date well before the return is filed.

Some states require unanimous owner consent. Some allow a majority. Some let individual owners opt in or out.

Rates differ. Some states apply the top individual rate, some apply a flat rate, and some apply a rate that differs from what the owner would have paid individually. Where the entity rate exceeds the owner's effective rate, the credit may not fully compensate.

Credit mechanics differ. A refundable credit is generally better than a non-refundable one, and an income exclusion approach behaves differently from a credit approach when the owner has other income in the state.

Because of this variation, the analysis is state specific and must be run against the actual statute rather than a general description.

The Federal Deduction Timing

Notice 2020-75 confirms the deduction is allowed in computing the entity's non-separately stated income. For a cash method entity, that means the deduction lands in the year the tax is actually paid.

An entity that pays its full state liability by December 31 deducts it that year. An entity that pays in April with the return deducts it the following year.

This creates an actionable year-end item. Making the PTET payment before year end accelerates the federal deduction by a full year, which for a first-year election means capturing the benefit immediately rather than a year later.

Interaction With the QBI Deduction

The PTET payment reduces qualified business income, because it reduces the entity's non-separately stated income.

For an owner claiming the 20% qualified business income deduction under IRC Sec. 199A, that means the PTET reduces the QBI deduction by 20% of the payment.

On a $54,000 PTET payment, the QBI deduction falls by roughly $10,800, reducing the net federal benefit. The election is usually still worthwhile, but the benefit is smaller than the headline number for owners with a full QBI deduction.

For owners in a specified service trade or business above the phase-out, where no QBI deduction is available, there is no offset and the full benefit is retained.

Worked Example: Three-Partner Firm

A firm operates in a PTET state with a 6.5% rate and allocates income equally among three partners, each receiving $780,000. All three are residents of the state and itemize.

Without the election, each partner pays approximately $50,700 of state income tax personally, of which almost none is deductible federally given the SALT cap and their property taxes.

With the election, the entity pays $152,100 of state tax and deducts it. Each partner's K-1 income falls to $729,300, and each receives a state credit for their share of the entity tax.

The federal deduction of $50,700 per partner at a 37% rate is worth $18,759 each, or $56,277 across the firm.

The firm is a specified service trade or business above the phase-out, so no QBI deduction is lost. The full benefit is retained.

The election is made by the state's deadline, unanimous consent is documented, and the full payment is made by December 31 to secure the deduction in the current year rather than the next.

Frequently Asked Questions

Is the pass-through entity tax election legitimate?

Yes. IRS Notice 2020-75 confirmed that state income taxes paid by a partnership or S corporation are deductible in computing the entity's non-separately stated income and are not subject to the individual SALT cap under IRC Sec. 164(b)(6).

Can a single-member LLC make the election?

Generally no, because a disregarded entity is not separate from the individual for this purpose. Owners in PTET states sometimes add a genuine second member or elect S corporation status specifically to access the election.

Does the election reduce my QBI deduction?

Yes. The PTET payment reduces qualified business income, so an owner claiming the full 20% deduction under IRC Sec. 199A loses 20% of the payment in QBI deduction. Owners in a specified service business above the phase-out have no offset and keep the full benefit.

When should the entity pay the tax?

By December 31 for a cash method entity. The federal deduction lands in the year of payment, so paying before year end captures the benefit a full year earlier than paying with the return in April.

Can the election make me worse off?

Yes, in several cases: owners who take the standard deduction, nonresident owners in states that do not credit another state's PTET, owners already using state credits, and owners in a loss year. The analysis should be run owner by owner, not just at the entity level.

The Pass-Through Entity Tax Election: A Real Workaround to the SALT Cap