State Pass-Through Entity Tax: Should You Elect It?

What is a pass-through entity tax, and how does it affect the SALT cap?

A pass-through entity tax, often called PTET, is a state income tax paid by a partnership or S corporation on income that otherwise passes to its owners. Under IRS Notice 2020-75, a qualifying payment reduces the entity's federal income or increases its loss. It is not an itemized tax deduction claimed by each owner, so it does not use that owner's personal state and local tax (SALT) limit.

The owner usually receives a related state tax credit, deduction or exclusion. The value of that benefit depends on the state's law; the federal deduction does not guarantee a full state credit. The tax must be imposed on and paid by the entity, not merely paid by the entity on an owner's behalf, to meet the notice's definition.

Is the election still useful with the higher SALT limit?

Sometimes. The personal SALT deduction limit is $40,400 for most filers, half that for married people filing separately. It starts to fall when modified adjusted gross income exceeds $505,000 (half that threshold for married filing separately), by 30% of the excess, but cannot fall below $10,000 (half that for married filing separately). The higher limit lasts through the years specified in the statute; the amount changes after this page's tax year.

If an owner itemizes and could deduct the same tax personally, moving it to the entity may give no federal benefit and can raise federal tax by shrinking the owner's QBI deduction. Self-employment tax or income-based limits can change that result. An owner taking the standard deduction, or whose other state and local taxes already fill the personal limit, may gain more. Compare the owner's actual Schedule A deduction before and after the election, not just the entity tax payment. Schedule A instructions also bar deducting an amount there when it was deducted elsewhere.

Which businesses and owners can participate?

Eligibility comes from each state's law. Notice 2020-75 covers qualifying payments by partnerships and S corporations; it does not create a state election for every business.

A single-member LLC considering S corporation taxation has a separate federal choice; see whether to elect S corporation status.

Who gains, and who could lose?

The election is most promising when every affected owner can use the state benefit and the entity deduction replaces a personal state tax payment that would not have produced an equal federal deduction. A full state credit is not enough by itself: a smaller qualified business income deduction, reduced use of the personal SALT deduction, credit limits and filing costs can offset the gain (IRS notice; IRS QBI guidance).

An owner can lose if usable credits and deductions do not offset the tax cost. Check the state's tax base as well as credit eligibility: California and New York can allow qualifying trusts to claim credits, while income of corporate and upper-tier partnership owners generally does not enter their PTET bases (California FTB; New York DTF). California's credit is nonrefundable, with unused credit carried forward for a limited period; New York's credit can be refunded. In California, only consenting qualified owners receive the credit, although the election binds all owners. Compare each owner's result and agree how the entity payment affects cash and distributions before electing.

How much could the election save?

Calculate the difference in combined federal and state tax for every owner, then add those differences. A rough federal starting point is the new entity deduction times the owner's marginal federal tax rate. Reduce that estimate for any lost personal SALT deduction and any reduction in the owner's qualified business income (QBI) deduction. The entity deduction can also lower modified AGI and restore some phased-down personal SALT limit; recalculate it after the election. Then compare state credits with the state tax the owner would otherwise pay. Notice 2020-75 explains the entity deduction and lower K-1 income; IRS QBI guidance explains why eligible business deductions reduce QBI.

Use projected income, owner residency and tax payments for the same year. The IRS notice places the federal deduction in the payment year. If the entity pays after year-end, the deduction may come later. In New York, an eligible owner claims the credit for the PTET return's tax year regardless of payment date, so the deduction and credit can fall in different years.

Does PTET lower QBI or self-employment tax?

A qualifying PTET payment generally lowers QBI when it is attributable to an eligible trade or business, so the owner's QBI deduction may shrink. For a general partner, it may also reduce net earnings subject to self-employment tax because ordinary partnership income enters that calculation. These effects follow from the entity deduction in Notice 2020-75, the IRS definition of QBI and the Form 1065 self-employment worksheet; the notice itself does not separately promise either result.

The self-employment result depends on the partner's status and the income involved. Limited partners' distributive shares generally have different self-employment treatment, while service guaranteed payments can remain subject to that tax (Form 1065 instructions). An S corporation shareholder's K-1 income is not wages, and PTET does not by itself reduce wages paid to the shareholder.

How and when does the entity elect?

The entity makes the election under the particular state's procedure, often annually. Do not assume filing an entity return alone makes the election: New York requires an authorized person to opt in and sign online by March 15 (March 16 for this page's tax year), while California requires a completed FTB 3804 with a timely filed original entity return (New York DTF; New York filing dates; California FTB). New York's election window for this page's tax year has closed.

An electing New York entity must also file a separate online PTET return by March 15 after the PTET year, even if no tax is due. Request any PTET filing extension separately by that date; it does not extend the time to pay (New York FAQ).

New York PTET uses a calendar year even for a fiscal-year entity. It elects, files and pays for the calendar year in which its fiscal year ends (New York DTF).

Before electing, gather each owner's residency, tax classification, consent where required, projected share of state-source income, personal SALT position and ability to use the state credit. These facts determine whether an entity-wide election helps the owners as a group.

When are payments due, and what if one is missed?

The payment schedule is separate from the election deadline and differs by state. Late or short payments can cost credits, penalties or interest, even when the election itself survives (California FTB; New York DTF).

For a precise due date, check the state's holiday rule and tax year. California accepts Web Pay, software electronic funds withdrawal or the FTB 3893 voucher; designate electronic payments as PTE payments and pay electronically if mandatory e-pay applies. New York requires online ACH debit.

How does PTET appear on the K-1 and state return?

The federal K-1 generally shows a lower share of income or a larger share of loss rather than a separate federal deduction for the owner's share of qualifying PTET (Notice 2020-75). The owner's state return then follows its own credit and income-adjustment instructions. Do not deduct the same entity payment again on the owner's federal Schedule A (IRS Schedule A instructions).

California owners claim their qualified credit with FTB 3804-CR; the entity adds back its federally deducted PTET when calculating California net income. New York partnerships put each eligible partner's credit share on the state partner schedule, while New York S corporations provide an owner statement. A New York claimant attaches Form IT-653 to the state return and adds back the credit amount (California FTB; New York DTF). Neither state allows the PTET credit on a nonresident group return; an eligible owner must file an individual state return to claim it (California FAQ; New York DTF). Federal and state K-1 income can therefore differ.

What if owners live in different states?

Model each resident's home-state credit before making the source-state election. New York may credit substantially similar PTET paid elsewhere on income from that jurisdiction, but a resident claiming the credit must add the corresponding out-of-state PTET back to New York income. California residents apply the PTE credit after the other state tax credit and must adjust that credit's net-tax calculation; model both together. For a New York S corporation, the resident-entity calculation requires every shareholder to be a New York resident; otherwise the standard calculation generally uses New York-source income.

For each owner, identify the state of residence, where the entity earns income, the credit claimant, and whether the home state recognizes the entity tax. PTET does not end California's nonresident withholding requirement; check each state's withholding rules separately. Keep the entity's payment record and each owner's state credit statement. Mixed owner types or several states can turn a federal deduction into an uneven result, so review the combined returns before an irrevocable election.

Example

Illustrative US dollars only. One S corporation owner has $100,000 of otherwise eligible business income. The corporation pays $10,000 of qualifying PTET and the owner receives a usable $10,000 state credit. Assume the owner would otherwise get no additional personal SALT deduction for that tax, has a 24% marginal federal rate, and can deduct 20% of QBI without other limits.

The entity deduction cuts income on the federal K-1 by $10,000. It also cuts the QBI deduction by $2,000, leaving $8,000 less federal taxable income. The simplified federal saving is $1,920 ($8,000 × 24%). The $10,000 state credit replaces $10,000 of state tax the owner would otherwise pay; it is not another $10,000 saving. A different personal SALT position, credit rule or QBI limit would change the calculation.

Different for you?

• Owners live in several states, or include companies or trusts: the credit may differ by owner. Bring the ownership list, residency, projected state income and prior state returns to tax preparation before the entity elects.
• Your partnership has a foreign partner: PTET does not replace federal withholding on that partner's effectively connected income; see foreign-partner withholding (IRS).
• Your LLC is considering S corporation taxation: that federal choice has separate rules; see whether to elect S corporation status.
• You need the underlying K-1 rules: see how S corporations are taxed or how partnerships are taxed.
• You also owe California's minimum tax or LLC fee: those are separate from PTET; see California minimum tax and LLC fee.
• You want to compare other lawful deductions: see lowering your business tax.