State Pass-Through Entity Tax (PTET): The SALT Cap Workaround for S-Corp and Partnership Owners

The pass-through entity tax is the most widely adopted response to the SALT deduction cap (now $40,000 under OBBBA, $20,000 MFS), and it works because the IRS acknowledged in Notice 2020-75 that entity-level state income taxes paid by a pass-through entity are deductible by the entity as a business expense under IRC 164, not subject to the individual SALT limitation. The concept is straightforward: instead of the business income flowing through to the owners and the owners paying state income tax on their individual returns (where the SALT cap limits the deduction), the entity elects to pay the state income tax directly, deducts the payment as a business expense on the entity’s return, and reduces the K-1 income passed through to the owners. The owners then claim a credit on their individual state returns for their share of the entity-level tax, so they aren’t double-taxed at the state level. The net effect is that the state income tax becomes a federal above-the-line deduction (through reduced K-1 income) rather than a below-the-line itemized deduction subject to the SALT cap. This produces a federal tax savings equal to the difference between the full deduction of the entity-level tax and what the owner could have deducted under the SALT cap.

How much does the PTET election save?

How does business nexus work for state tax purposes?

Nexus is the minimum connection a business must have with a state before that state can impose its taxes. Physical nexus is established by having employees, property, or inventory in a state. Economic nexus, which has expanded significantly since the Supreme Court’s Wayfair decision (2018), can be triggered by exceeding revenue or transaction thresholds in a state (commonly $100,000 in sales or 200 transactions). Once nexus is established, a business may owe the state’s income tax, franchise tax, sales tax collection obligations, and payroll tax withholding for employees working in that state. Many states offer voluntary disclosure agreements (VDAs) that limit look-back periods and waive penalties for businesses that discover they have unfiled state obligations.

How does choosing the wrong entity structure affect my taxes?

The wrong entity can cost thousands in unnecessary taxes annually. A sole proprietor earning $120,000 pays roughly $17,000 in self-employment tax; an S-Corp paying a $70,000 reasonable salary saves approximately $7,650 in FICA on the remaining $50,000. Conversely, an S-Corp for a business earning $40,000 creates more compliance cost (payroll, separate return) than the FICA savings justify. A C-Corp creates double taxation on distributions unless the owner takes all profits as salary, which maximizes FICA. Switching later is possible but can trigger tax consequences: converting a C-Corp to an S-Corp subjects built-in gains to a 5-year recognition period.

How do you handle state tax obligations when your business operates in multiple states?

Multi-state businesses must determine their filing obligations in each state based on nexus (physical presence, economic thresholds, or factor-based), then apportion income using each state’s apportionment formula. Most states use a single-factor sales apportionment formula that assigns income based on where your sales are delivered, though some states still use a three-factor formula weighting sales, payroll, and property. Throwback and throwout rules in some states can increase your tax liability by reassigning sales revenue from states where you aren’t taxable back to your home state. The pass-through entity tax election available in most states allows S corps and partnerships to pay state income tax at the entity level and claim a federal deduction, effectively bypassing the $10,000 SALT deduction cap for owners.

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.