A few years ago, the Tax Cuts and Jobs Act (TCJA) introduced significant changes to the tax landscape that continue to impact high-net-worth individuals and business owners. One notable adjustment was the temporary imposition of a cap on state and local tax (SALT) deductions, limiting taxpayers to a $10,000 deduction annually. For some taxpayers, this limitation may have substantial implications.

Understanding the SALT Cap Limitation

The TCJA’s $10,000 cap on the amount of state and local (income and property) taxes that can be deducted on a federal tax return applies only to individuals – and not to business entities. For high income individuals residing in states with high tax rates, this cap significantly reduces the potential benefits of itemizing deductions.

The Pass-Through Entity SALT Cap Workaround

In response to the SALT cap, states began to enact laws that enable business owners, particularly those with significant business income, to utilize their pass-through entities as a conduit for managing state and local tax liabilities. Instead of paying their state tax liability directly and picking up the deduction on their individual tax return, business owners can instead opt to pay these taxes through their pass-through entities.

How Does It Work?

1. Entity Makes a Pass-Through Entity Tax (PTET) Election: A business owner makes an election for the PTET (in states that permit it), which makes the business subject to state tax for that year that can be paid at the entity level.
2. Entity Pays State Taxes, Offsetting Federal Taxable Income: Pass-through entities, whether an S-corporation, partnership, or LLC, pay state taxes directly from the business itself. These taxes are fully deductible at the entity level, rather than being subject to the $10,000 SALT deduction cap at the individual level.
3. State Tax Credits: Depending on the state’s tax laws, business owners may also be eligible for a state tax credit on their personal return that helps offset taxes paid at the entity level. However, it should be noted that the credit in some states may not cover 100% of the PTET paid (which means some portion of income may be effectively double taxed at the entity and individual level).

Considerations and Implementation

While the PTE SALT Cap Workaround offers significant tax planning opportunities, it’s essential to navigate this strategy prudently and in consultation with qualified advisors. For example, business owners that have operations in multiple states must consider how making the election will impact their overall tax liability and whether any state tax credit will offset taxes paid in the other states they are required to pay taxes in. For businesses with multiple owners, making the PTET election may benefit some owners and not others. Back in 2020 the IRS issued Notice 2020-75, expressly approving the PTET as a SALT cap workaround for any “Specified Income Tax Payments” made after the Notice was issued in November 9, 2020. Following the issuance of the Notice, the PTET strategy gained additional traction and is now available in over 30 states.

Conclusion

Business owners with equity in pass-through entities operating in any state that has enacted legislation permitting the PTET strategy should consider whether a PTET election makes sense. The election presents a valuable opportunity for our business owner clients to manage their state and local tax liabilities effectively while maximizing tax efficiency. Should you wish to explore this strategy further or require personalized guidance tailored to your unique financial situation, we encourage you to reach out to our team of experts. Together, we can develop a comprehensive planning strategy aligned with your long-term financial goals.