Let’s be honest—the Tax Cuts and Jobs Act of 2017 threw a lot of business owners a curveball. One of the biggest? That $10,000 cap on state and local tax (SALT) deductions. For owners of S corporations, partnerships, and LLCs (what the tax code calls “pass-through entities” or PTEs), it felt like a double hit. You pay state income tax on your business profits, personally, but suddenly you couldn’t fully deduct it on your federal return.
Well, enter the state-level workaround. It’s a bit of legislative jujitsu that’s become a critical tax planning tool. Here’s the deal: we’re going to break down pass-through entity taxes and how they interact with the SALT deduction cap workarounds. No jargon avalanches, I promise. Just clear, actionable insights.
The SALT Cap Problem: Why PTEs Were Pinched
First, a quick rewind. Before 2018, if your PTE earned $500,000 and your state income tax rate was 5%, you’d pay $25,000 in state tax. You’d then itemize and deduct that full $25,000 on your Schedule A. Simple.
The TCJA changed the game. It capped the SALT deduction at $10,000 for individuals. So, in our example, you’re still paying $25,000 to the state, but you can only offset your federal tax bill by $10,000 of it. That stings. It effectively increased the after-tax cost of state taxes for successful business owners—a genuine pain point that sparked innovation.
The Elegant Workaround: Electing a Pass-Through Entity Tax
States, keen to keep their tax bases happy (and intact), got creative. They passed laws allowing PTEs to elect to pay state income tax at the entity level. Think of it like rerouting a river. Instead of the tax flowing through to you, the owner, and hitting the deduction cap, the business itself pays the tax directly.
Why does this matter? Because the federal tax code doesn’t cap business expense deductions. The PTE tax paid by the business is deducted in calculating its federal taxable income. It bypasses your personal Schedule A entirely, effectively circumventing—or let’s say, optimizing around—that pesky $10,000 SALT limit.
How the PTE Tax Election Works: A Step-by-Step View
It’s not automatic. You have to make an election, and the rules vary wildly by state. But the general flow looks something like this:
- Step 1: The Election. Your LLC or S-corp elects to pay state income tax on its profits. This is usually an annual choice, and it’s often irrevocable once made for that tax year.
- Step 2: The Business Pays. The entity calculates and pays the state tax. This reduces the distributable income that flows to your K-1.
- Step 3: The Federal Deduction. The entity claims the tax paid as a deduction on its federal return (Form 1065 or 1120-S). This lowers the business’s federal taxable income, so the income passed to you is already net of that state tax.
- Step 4: The Owner’s Credit. Here’s the beauty part. Most states give you, the owner, a refundable or nonrefundable tax credit for your share of the tax the entity paid. You use this credit on your personal state return to avoid double taxation. It’s a wash at the state level, but a win at the federal.
Key Considerations and State-by-State Chaos
Not all PTE tax regimes are created equal. Honestly, it’s a patchwork quilt out there. Some states, like California and New York, have them. Others don’t. And the specifics? They’re all over the map.
| State | Common Election Name | Key Nuance |
| California | Elective Tax (PIE) | Tax rate is 9.3%; credit is nonrefundable but can be carried forward. |
| New York | Pass-Through Entity Tax (PTET) | Has a graduated rate structure and a specific annual election window. |
| Illinois | Illinois PTE Tax | Rate is 4.95%; credit is refundable, which is a huge benefit. |
| Colorado | PTE Tax Election | Elective for tax years beginning in 2022 onward; credit is nonrefundable. |
You see the variations? The type of credit—refundable vs. nonrefundable—is a massive deal. A refundable credit means if it exceeds your state tax liability, you get cash back. A nonrefundable one just reduces your liability to zero. Big difference.
Who Benefits Most? And The Potential Pitfalls
This strategy isn’t a magic bullet for every PTE owner. It tends to shine for those in high-income brackets and in states with high income tax rates. If your personal SALT deductions were already maxing out that $10,000 cap, the workaround can provide meaningful savings.
But watch your step. There are complexities:
- Quarterly Estimates: The entity may need to make estimated tax payments, adding to your administrative load.
- Partner Consensus: In multi-owner entities, all owners typically must consent to the election. Aligning everyone’s tax situations can be… a conversation.
- Federal Scrutiny: The IRS has blessed these workarounds (see Notice 2020-75), but the rules are nuanced. Getting the reporting wrong on your K-1s and state returns invites trouble.
- Alternative Minimum Tax (AMT): In some cases, the benefit might be reduced if you’re subject to AMT. It’s a layer you have to model.
Optimizing Your Approach: It’s About Integration
Optimizing pass-through entity taxes isn’t a standalone move. It’s a chess piece in your overall tax strategy. You need to consider it alongside your income projections, your entity’s structure, and even your estate plan.
For instance, making the election in a high-income year makes perfect sense. In a lower-profit year? Maybe not. And what about states where you have nexus but don’t live? The workaround might apply there, too. The point is, this isn’t a “set it and forget it” checkbox. It’s an annual analysis.
Talk to your CPA. Seriously. The cost of professional advice here is usually dwarfed by the potential savings and the peace of mind that comes from knowing it’s done right. They can run the numbers—factoring in your specific state’s rules, your income, and other deductions—to see if the math works in your favor.
The Future of the Workaround
Look, the SALT cap is a political football. It’s set to expire after 2025, but who knows if it will be extended, modified, or scrapped. These state PTE tax regimes, however, have taken on a life of their own. Even if the cap sunsets, some states might keep their PTE taxes as a permanent feature—they can be a more stable revenue source.
So the landscape will keep shifting. The most adaptable business owners—the ones who see tax planning not as a once-a-year chore but as an ongoing part of their financial health—will be the ones who stay ahead. They turn complexity into opportunity, one calculated election at a time.
In the end, understanding these workarounds is about reclaiming a bit of agency. It’s about navigating a system of cliffs and caps with a better map. And that, well, that’s just good business.
