Deducting Your State Income Taxes with a Pass-Through Entity

Many states have adopted an optional pass-through entity (PTE) tax that effectively enables some business owners to deduct state income tax on their business income without limit.

By , J.D.

The personal federal income tax deduction for state and local income taxes and property taxes ("SALT" for short) is capped at $10,000 per year through 2025. So, if you live in a high-tax state like California or New York and owe $10,000 or more in property tax, that tax alone will use up your $10,000 deduction. You'll get no federal deduction at all for the state income taxes you pay.

However, a majority of states have now adopted an optional pass-through entity (PTE) tax that effectively enables many business owners to deduct state income tax on their business income without limit. In these states, a PTE's owners can elect to have the PTE pay the state income tax due on the PTE's business income that would otherwise be paid on their personal tax returns. The PTE then claims a federal business expense deduction for the state income tax payments. The $10,000 SALT cap does not apply to such payments by a business. The PTE's owners then get a state income tax credit for the state income tax the PTE paid or pay state income tax on the reduced amount of PTE income. This arrangement has been approved by the IRS. (IRS Notice 2022-75).

For example, ABC, LLC is a two-member California LLC with $400,000 in net income. Both members make the PTE tax election, and the LLC pays a 9.3 percent PTE tax to California. This $37,200 payment is a deductible business expense by the LLC, reducing its net income to $362,800. Each LLC member reports $181,400 of net income ($362,800 X 50%) on their federal K-1, resulting in a $43,536 federal income tax bill. Without the PTE tax deduction, they would have had to pay $48,000. When the members file their individual California income tax returns, they each report $200,000 of net income from ABC, LLC and take a tax credit of $18,600 against their individual California income tax. As a result, they pay no individual California income tax on their LLC income. Meanwhile, they each save $4,464 in federal income tax.

State PTE taxes are only for owners of pass-through entities: partnerships, limited partnerships, S corporations, and multi-member LLCs. They can't be paid by sole proprietors or owners of single-member LLCs. PTE taxes have been enacted in the following states: Alabama, Arizona, Arkansas, California, Colorado, Connecticut, Georgia, Idaho, Illinois, Kansas, Louisiana, Maryland, Massachusetts, Michigan, Minnesota, Missouri, Mississippi, New Jersey, New Mexico, New York, North Carolina, Ohio, Oklahoma, Oregon, Rhode Island, South Carolina, Utah, Virginia, and Wisconsin. If you have a multi-owner pass-through business in one of these states, check your state tax agency's website for information on its PTE tax. The tax rates and procedures for making the PTE tax election and paying the tax vary from state to state.

Effective date: June 23, 2022