In 2017, “The Tax Cuts and Jobs Act (TCJA) set the state and local tax (SALT) limitation for individual taxpayers at $10,000. This limit on state taxes has impacted high-earning individuals and individuals living in states with high state and local taxes compared to others. In response, the states have implemented a workaround system using Pass-Through Entity Tax (PTET).

Pass-Through Entity Tax (PTET)

PTET is a tax strategy that has been adopted by 36 states, allowing businesses that are organized as pass-through entities (partnerships, S corporations, and limited liability companies) to pay state income tax at the entity level. This is beneficial in two ways: on a federal level, a business is allowed to deduct the state taxes paid as a business expense and the business owner receives the benefit for the state taxes paid on their behalf.

The rules surrounding PTET vary by state, as each state has its own requirements and structures for participation. Each state has specific eligibility criteria and income thresholds, and each state has their own tax rates. Reach out to a tax professional for more information.

SALT Deduction Cap

The SALT Deduction originated with the original 1913 tax code as a safety measure to avoid double taxation. The SALT Deduction has been a talking point throughout the history of the Tax Code and has been debated on regarding various ways to handle the future of the deduction.

Before the TCJA in 2017, SALT Deduction was uncapped as an itemized deduction. This greatly impacted individuals that live in states with high income taxes, such as California, New York, and Connecticut, being taken as a large part of their itemized deduction helping to reduce their federal tax liability.

The legislation in the TCJA was aimed at promoting economic growth and, at the same time, simplifying the tax code. The SALT cap was a measure to help with this goal; by implementing the SALT cap, it made room for the IRS to raise the standard deduction and lower the business tax.

PTET: SALT Cap Workaround

States implemented the Pass-Through Entity Tax (PTET) workaround in response to the $10,000 cap on SALT deductions. This cap limits the amount of state and local taxes that individual taxpayers could deduct on their federal returns. This restriction became a heavy tax burden on residents of high-tax states.

The use of PTET allowed states to maintain their tax revenues without challenging federal law, operating within the existing structure of business taxation, giving individuals a way to around the SALT cap deduction.

PTET does not benefit everyone primarily due to its design to help business owners who operate through pass-through entities. Individuals receiving W-2 wages and Schedule C entities are unable to utilize the workaround and will continue to be at the $10,000 cap. With the TCJA sunset set for December 31, 2025, it is important to keep up with changing politics. We could see a whole new SALT deduction approach implemented, which could also impact the reasoning and methodology of the use of PTET.