One of the enacted laws of Tax Cuts and Jobs Act (TCJA) in 2017 is the State and Local Tax (SALT) Deduction Cap, limiting the federal tax deduction an individual can claim for their state and local taxes paid. 

Under the SALT cap, individual taxpayers who itemize their deductions on their federal income tax returns are limited to a maximum of $10,000 ($5,000 for married individual filing a separate return) on their total state and local taxes paid. These taxes include the following: 

• Real property taxes 
• Personal property taxes 

• Income, war profits, and excess taxes; and 
• General sales taxes 

Before the enactment of 2017 TCJA, the deductibility of state and local taxes was unlimited. And although the SALT deduction limit is effective starting 2018 to 2025 only, it has significantly affected individual taxpayers especially those living in high-tax states. 

An IRS-approved workaround on the SALT Cap 

Ever since the SALT Cap was passed, several states have been finding ways to mitigate its effect on its residents. Some have proposed to increase the maximum limit or to terminate the SALT Cap earlier than 2025. 

Fortunately, last November 2020, the IRS issued Notice 2020-75 allowing certain Pass-through Entities (PTEs), specifically partnerships and S Corporation, to pay its state income taxes on the entity level and claim it as a business deduction without limitation. 

What is PTE Tax? 

A PTEs main advantage over other business forms is its ability to avoid double taxation. A PTEs business income is not subject to tax but rather passes through its owners or partners and are taxed according to their individual tax bracket.  

But when the partners or shareholders of PTEs elect to adopt PTE Tax, the state taxes on the PTEs income will have to be paid at the entity level. The PTEs can then claim it as a business deduction without being subject to the $10,000 SALT limitation. 

Example 

Let’s say, John owns an S Corp that earned $150,000 in the state of California. His current state tax rate is 9.3% while his federal tax rate is 24%. He has already paid $10,000 for real property tax.  

As a PTE, the S Corp would normally pass the taxable income to John and will have to pay $13,950 in state tax. John will then report this on his federal tax return, but he won’t be able to claim it as a deduction since his real property tax has already maxed out the $10,000 SALT allowable deduction. Therefore, he must pay $36,000 federal tax on his income from the S Corp based on the full $150,000 PTE income. 

With a PTE Tax election, the S Corp will have to pay with an elective tax rate of 9.3% or $13,950 state tax and claim it as a business deduction lowering his taxable income to $136,050. When he files his federal tax return, he will then receive a tax credit* for the taxes paid by the PTE. His new federal tax amount of $32,652 is based on the net taxable income saving him a total of $3,348 in federal tax. 

*Other states exclude the electing PTE’s income from the owner’s individual tax computation instead of providing tax credits. 

Points to Remember 

• The rules, rates, and eligibility vary from state to state. 
• Unfortunately, not all states offer a PTE Tax election. Hawaii is the latest addition to the list of states that allow PTE Tax election after it was enacted last June 2023. While Connecticut is the only state where PTE Tax is mandatory. 
• In general, only partnerships, LLCs taxed as partnership, and S corporations can make PTE Tax elections. Each state may further provide disqualification rules. 
• The deadline and procedure to make PTE Tax election vary by state. 

 

Need help with your taxes? Contact us toll-free (855)529-1099 or make an appointment and let our tax experts guide and help you stay compliant with the IRS’ tax rules and regulations. 

Want to learn more? 

You may want to consult and work with 1099 Accountant – We offer online bookkeeping, online advisory services and online tax and accounting services. We offer reasonable rates. We only work with independent contractors, freelancers, and one-person business. We work with locum tenens from California to New York City and everywhere in between. Yes, even Hawaii! 

Contact us toll-free (855)529-1099 or make an appointment for a free consultation. Contact Us