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Navigating the Pass-Through-Entity Tax as a Workaround to State and Local Tax Deduction Limits by Maxwell Jewell, CPA, MST

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Posted on August 25, 2025 by Maxwell Jewell

Taxpayers in high-income-tax states breathed a collective sigh of relief with the July 2025 passage of the One Big Beautiful Bill (OBBB), which provides a temporary increase to the cap on the state and local tax (SALT) deduction from $10,000 to $40,000 in 2025 through 2029, subject to income limitations.

While the new law preserves the optional pass-through entity tax (PTET) that several states introduced to help wealthy taxpayers work around the deduction limit, business owners, in particular, must understand how PTET requirements vary widely from one state to the next and the corresponding impact those decisions will have on their ultimate tax position. In some cases, a PTET election may not make sense for taxpayers in all jurisdictions where they operate.

Background

The $10,000 SALT cap introduced in 2018 came at a considerable cost to taxpayers who could previously claim deductions on their federal tax returns for payments of state income, sales, property and real estate taxes. Those most impacted by the law include high-income taxpayers who previously relied on those SALT deductions to reduce their federal income tax liabilities. In response, 36 states and New York City have enacted laws enabling qualifying residents to make PTET elections that essentially help them circumvent the cap and maximize their state and local tax deductions.

The profits of pass-through entities (PTEs), such as S corporations, partnerships and limited liability companies (LLCs), typically flow to their owners, who pay taxes on those amounts at their individual tax rates. However, under a PTET regime, those businesses may elect to pay state income taxes at the entity level, removing them as personal owner expenses subject to the SALT cap. Companies can then deduct those payments as business expenses on their federal tax returns. This essentially reduces the amount of business income that passes to the owners’ personal tax returns and provides them with corresponding state tax credits against their individual income tax liabilities.

Before delving into the challenges taxpayers may encounter when applying the PTET rules from state to state, it is important to recognize that the temporary SALT cap expansion introduced by the OBBB is subject to income limitations, which may prevent high-income taxpayers from benefiting from the full $40,000 deduction. More specifically, the deduction phases down when taxpayers’ modified adjusted gross income (MAGI) exceeds $500,000 for single taxpayers and married couples filing joint tax returns. Once single or jointly filing taxpayers’ MAGI is $600,000 or more, the deduction cap resets at $10,000.

Conflicting Rules from State to State

Businesses looking to take advantage of PTETs in states where they operate or where their owners reside must recognize that the tax rates, election deadlines and rules for calculating their tax base and applying the credit can vary widely from one jurisdiction to the next. This can become a complex and time-consuming reporting compliance environment for entities operating across multiple states with often conflicting laws.

For example, taxpayers in states that include Arizona, California, Connecticut, Illinois and New Jersey can elect into their respective PTET regimes by March 15 after the close of a tax year. In stark contrast, PTEs in New York do not benefit from having their annual financial documents in hand before electing into the state’s PTET for a particular year. Instead, they must decide whether an election makes sense for them by March 15 of the tax year to which the election would apply. This requires considerable speculation about how owners expect their businesses to perform throughout the remainder of the year. Should they make an election in March and pay the required quarterly estimated PTETs through June, only to experience a significant downturn in September, they may find they overpaid PTETs to the state. Under these circumstances, they will still need to file PTET returns for that year and request a refund of all overpaid tax amounts, which could take time to process. New York state does not allow pass-through entity owners and shareholders to apply estimated PTET overpayments to the following year, nor does it permit entities to transfer estimated PTET payments between related parties or to any other tax liability. This is not the case in states, such as California, that allow entities to apply estimated PTET overpayments to the following tax years.

This lack of uniformity from state to state is not the only challenge businesses encounter when deciding whether to make a PTET election in each jurisdiction. Consideration must be given to how the entity is structured, the tax treatment of its owners and their percentage of business ownership, where owners are domiciled, whether they have individual income tax return filings in states where they are not residents and how much income is allocated to each jurisdiction based on the states’ unique apportionment rules.

When considering a potential liquidity event, it is important to consider how a PTET election may affect a future business sale or merger. For example, owners of pass-through entities generally prefer to sell stock rather than assets to yield beneficial long-term capital gains tax treatment on the sale proceeds. However, a stock sale for a business that elects into the PTET regime could result in state taxes imposed at the shareholder level and nullify the election’s intent to circumvent the SALT cap. By contrast, an asset sale will decrease the taxable income allocated to the shareholders and reduce their total tax costs. Buyers also prefer this type of transaction due to the step-up in tax basis they receive on the target company’s assets and their ability to recover the sales costs of those assets through depreciation and amortization.

A potential strategy PTEs can employ when selling to a private equity fund is to consider an F reorganization with a corresponding PTET election. This would involve creating a new company taxed as an S corporation to hold all of a business’s assets. After the PTE transfers all its assets to the holding company, the IRS considers it fully liquidated and disregarded for income tax purposes, and a sale or purchase of that operating company’s equity is then treated as an asset sale.

Pass-through entities must consider the complexity that PTET elections could add to their business tax compliance efforts. However, the potential savings for the entity and its shareholders or partners are worthy of deeper analysis.

About the Author: Maxwell Jewell, CPA, MST, is an associate director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where he provides tax and consulting services to high-net-worth families and businesses in the private equity and software sectors. He can be reached at the CPA firm’s New York City office at (332) 216-0006 or mjewell@bpbcpa.com.