Ever since the Tax Cuts and Jobs Act of 2017 (TCJA) capped the individual state and local tax (SALT) deduction at $10,000 annually, taxpayers and states have searched for legitimate ways to work around the limitation. The first of these efforts to gain approval from the IRS is a state-imposed entity-level tax on pass-through entities (PTEs), such as partnerships or S corporations. Many states passed legislation that allows PTE owners to elect to pay tax at the entity level as opposed to the owner level. PTEs that pay state income taxes at the entity level may then deduct the amounts paid when determining federal ordinary income, in effect creating a deduction for state income taxes that’s not subject to the $10,000 limitation. (The SALT deduction cap increased to $40,000 for 2025, or $20,000 for married individuals filing separately, and generally increases by 1% annually through 2029 before returning to $10,000 in 2030. The increased cap is reduced for taxpayers whose modified adjusted gross income exceeds applicable thresholds.)
Most states that impose an individual income tax have enacted some form of elective or mandatory entity-level tax for qualifying pass-through entities. The eligibility requirements, tax bases, election procedures, owner benefits, and resident-credit rules vary significantly by state.
When states began enacting pass-through entity tax (PTET) regimes, it was possible the election would favor one owner by reducing overall federal and state tax paid while increasing the overall federal and state tax paid by another owner.
Although many states have modified their PTET laws to address unintended results, material differences can remain among owners based on residency, ownership type, applicable tax rates, credit limitations, and the treatment of taxes paid to other states.
Therefore, it’s critical to consider the tax impacts of all owners — individuals and entity owners alike — when determining whether to make PTE elections.
How does a PTET election affect an individual owner’s tax computation?
The eligibility requirements as well as the tax computations can be quite burdensome depending on the facts and circumstances of the PTE and the state’s PTET laws. Some calculations may be simple if you have a PTE whose owners and entity activity are limited to one state. Unique challenges exist if the entity is a multistate business and its owners are residents of multiple states.
When it comes to computing income subject to tax at the state level, states generally use federal taxable income as the starting point and further adjust it based on individual state tax rules.
States use different methods to prevent the same income from being taxed twice. Some exclude or deduct PTET-taxed income from the owner’s state tax base. Others include the income and provide the owner with a credit for the entity-level tax. Additional differences arise when a resident owner seeks a credit for PTET paid to another state or when the ownership structure includes multiple tiers of pass-through entities.
The complexities can seem endless when considering all the differences among the various state-enacted PTETs.
Another aspect to consider when making the election is whether the PTET paid to a state is refundable at the owner or pass-through level. Some states, such as New York, allow for the credits to be refunded while other states, such as California, only allow for credits to be carried forward.
Because California’s elective tax is imposed at the entity level using a specified rate, while an owner’s personal income tax liability depends on the owner’s individual circumstances, an owner may not be able to use the full credit in the current year. Any unused amount is subject to California’s applicable carryforward rules.
In addition to different calculations based on residency, the type of PTE could impact how income is to be apportioned. Therefore, further consideration needs to be made based on whether the PTE is a partnership or an S corporation. The rules in place for S corporations aren’t always the same when computing the apportionment factor for partnerships. Because income might be apportioned differently for an S corporation owner as opposed to a partnership owner, the election can significantly impact various owners’ tax liabilities, the state in which returns are filed, and the state where the PTE owners reside.
A fluid situation with PTET provisions
Although most states have passed legislation allowing for PTE elections, some questions remain about the specifics to the mechanics of each PTET. Further, a number of states have made significant changes to PTET elections, such as due dates and allowing for credits for taxes paid to other states. The result is that taxpayers are attempting to comply with rules while at times only having access to limited guidance outside of statutory language and changing state laws. Additionally, the federal deduction for state taxes was set to expire after 2025, but the cap is both extended and temporarily increased due to the enactment of the One, Big, Beautiful Bill on July 4, 2025.
Some state PTET provisions originally contained sunset dates tied to the former federal SALT-cap expiration after 2025. Several states have since extended or revised their regimes, while other states may still need legislative action to continue or modify their provisions. Taxpayers should confirm the law applicable to each state and tax year before making an election.
If you have questions about the impact of a PTET election, either in your role as an executive at a PTE or as an owner of one, feel free to reach out to one of the authors to discuss the specific facts and circumstances of your situation.
