Tax Tip 6: Pass-Through Entity Tax (PTET) as a Tax Strategy

Let’s face it—the $10,000 SALT deduction cap introduced by the Tax Cuts and Jobs Act (TCJA) in 2017 has been a headache for small business owners, especially in high-tax states. That’s where the Pass-Through Entity Tax (PTET) comes in. Think of it as a clever workaround to help owners of pass-through entities (like LLCs, S Corporations, and Partnerships) bypass this cap.

Here’s how it works: Instead of paying state taxes on their personal returns—where the $10,000 SALT deduction cap applies—the business pays those taxes at the entity level. Since businesses don’t face the same deduction limits, this makes the state taxes fully deductible for federal tax purposes. Simply put, PTET shifts the tax burden in a way that allows owners to reclaim a valuable deduction.

Why PTET is Worth Considering

If your business operates in a high-tax state, PTET could save you thousands of dollars in federal taxes. Here are the key benefits:

1. Bypasses the $10,000 SALT Cap
   Individual owners face the SALT cap, but PTET allows your business to deduct state taxes as a business expense—no $10,000 limit here.
2. Lowers Your Federal Taxable Income
   By deducting state taxes at the business level, the pass-through income reported on your personal tax return is reduced. Less taxable income = smaller federal tax bill.
3. It’s Simple to Elect
   Most states with PTET programs make opting in a straightforward process. Plus, it’s usually a year-by-year decision, giving you flexibility.

How PTET Works: Breaking it Down

Here’s what happens when your business elects PTET:

1. The Election:
   Your business opts into PTET, usually by filing a form with your state tax authority.
2. Pay Taxes at the Entity Level:
   The business pays state income taxes based on its taxable income, treating those taxes as a deductible business expense.
3. Owners Get Credit:
   Individual owners get a credit on their state tax return for the taxes paid by the business, ensuring they don’t pay taxes twice on the same income.

Example of PTET in Action

Imagine you own an LLC in California with a net income of $500,000, split evenly between two owners:
• Without PTET:
  • Each owner reports $250,000 in income on their personal return.
  • At a 10% state tax rate, each owes $25,000 in state taxes.
  • But because of the SALT cap, each can only deduct $10,000, leaving $15,000 nondeductible.
• With PTET:
  • The LLC elects PTET and pays the $50,000 state tax at the entity level.
  • That full $50,000 is deductible as a business expense, reducing the LLC’s federal taxable income to $450,000.
  • Each owner’s pass-through income is now $225,000, and they receive a $25,000 credit on their state tax return for the taxes paid by the business.

Outcome:
By electing PTET, the $50,000 state tax is fully deductible at the federal level, saving the owners money they wouldn’t have been able to deduct otherwise.

Where PTET is Available

More than 20 states now offer PTET programs, including California, New York, New Jersey, Illinois, and Colorado. Each state has its own rules and deadlines, so it’s important to check the specifics where you operate.

What to Consider Before Electing PTET

While PTET can be a great strategy, it’s not always the best choice for every business. Here are some things to keep in mind:

1. Annual Election:
   • PTET is typically a year-by-year decision, so you’ll need to opt in each year to use it.
2. State-Specific Rules:
   • Some states have additional requirements, like varying tax rates or unique administrative steps.
3. Not Always Beneficial:
   • If the business owners are in lower tax brackets or the SALT cap doesn’t impact their deductions, PTET might not offer much of an advantage.
4. Coordination is Key:
   • PTET simplifies federal tax reporting but requires careful planning to ensure owners get their proper state tax credits.

Why PTET Matters

With the SALT cap expected to stay in place through at least 2025, PTET is one of the few tools available for pass-through entities to maximize their tax deductions. If your business operates in a state with PTET, it’s worth discussing this option with your tax advisor to see if it’s the right fit for you.

By using PTET strategically, you can reduce your federal tax burden while staying compliant with both state and federal laws—a win-win for your business.