Limits to the value of state and local tax deductions at the federal level (the so-called SALT cap) was one of the most contested elements of the 2017 tax overhaul. Unsurprisingly, the cap took center stage once again in negotiations over the recently passed tax and spending bill.
At least 36 states have taken action to limit SALT cap exposure, primarily in higher-tax states. Two primary workaround strategies — the charitable contributions workaround and the pass-through entity tax workaround — emerged soon after the SALT cap became the law, but only the PTET workaround has survived.
Although the Republican-backed legislation increased the SALT cap significantly, the cap is now subject to phaseout for high-income taxpayers, meaning that the PTET workaround remains highly relevant. Clients should remain wary, however, as the Internal Revenue Service has yet to release regulations formalizing the PTET workaround, and guidance on this strategy is lacking.
It remains unclear whether the Trump administration will invest the resources to either revoke Notice 2020-75, on expected rules around pass-through entity tax, or provide clarifying regulations. In the meantime, advisors should exercise caution when navigating the PTET workaround.
Increases to the SALT Cap
The 2025 megabill temporarily raised the $10,000 SALT cap to $40,000, and it will be adjusted by 1% annually through 2029.
The $40,000 cap phases out for taxpayers with modified adjusted gross income that exceeds $500,000, with a minimum $10,000 floor regardless of income. The cap will be reduced by 30% of the excess, if any, of the taxpayer's MAGI over the inflation-adjusted threshold amount.
Because of this phase-out, higher-income taxpayers may see limited usefulness from the increase to $40,000 — thus, the value of using PTETs as workarounds remains.
However, the legislation did not address the PTET strategy in any way.
SALT Workaround
After the 2017 tax overhaul, many states created PTETs in order to allow taxpayers to sidestep the SALT cap via a pass-through structure for partnerships and S corporations. Procedurally, many states allow the entity to elect application of the PTET — yet maintain the pass-through entity structure and therefore mimic the traditional C corporation structure.
The business pays the PTET at the entity level and is then able to deduct the payment as a business expense on its federal income tax return. This reduces the business’ taxable income and the amount of that income that is passed through to the individual business owner.
The state, in turn, provides a credit to the individual business owner to reduce or eliminate any state tax liability. The state’s tax revenue stream remains constant because the liability is shifted from the individual business owner to the business itself.
Via Notice 2020-75, the IRS has stated that it would release regulations providing that the entity itself would be entitled to deduct the PTETs if they are paid to the state or local jurisdiction. The IRS indicated that these PTETs would not be included when applying the SALT cap to the individual partner, LLC member or S corporation shareholder. This essentially allows taxpayers who use the pass-through entity structure to sidestep the SALT deduction cap.
Questions Over the PTET Strategy Remain
The IRS has not stated its legal rationale for allowing the PTET workaround while prohibiting the charitable contributions workaround.
For example, Notice 2020-75 does not specifically state whether the state or local PTET tax must be related to a trade or business. While some states do require that relationship, not all states have formally adopted this requirement.
The IRS notice does not specify how the federal deduction should be allocated among partners or S corporation shareholders. Partnerships may allocate the deduction using the substantial economic effect rules, for the benefit of the partner subject to the burden.
The 2020 notice is also unclear as to whether the PTET-related deduction can be taken by accrual-basis taxpayers if they have not technically paid the tax by year-end, assuming that the tax has been accrued by year-end.
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