The Pass-Through Entity Tax
The federal cap on the state and local tax (SALT) deduction — raised by OBBBA to $40,400 in 2026, and itself grinding down by 30 cents on the dollar above $505,000 of MAGI until it bottoms out at $10,000 (chapter “Tax Planning and Management”) — leaves owners in high-tax states deducting only a fraction of the state income tax they actually pay. The pass-through entity tax (PTET) is the legislatively sanctioned way around it. Whether it is worth electing in a given year now depends on where your income sits against that phaseout — a change from the $10,000-cap era, when the answer was always yes.
The mechanism is a reassignment of who pays the tax. A partnership or S-corporation elects to pay state income tax at the entity level instead of passing the liability through to the owners’ personal returns. Because the entity pays it, the payment is the entity’s deductible expense ( IRC §164, “Taxes”), and it reduces the business income flowing through to the owners’ K-1s — a full federal deduction for state income tax, taken above the individual SALT cap entirely. The owners then claim a credit (or an income exclusion) on their state returns for the tax the entity already paid. The IRS blessed the structure in Notice 2020-75, and roughly three dozen states now offer some form of it.
Two practical notes. First, treat the details as state-specific and time-sensitive: PTET regimes were enacted on staggered schedules and several were written with sunset dates tied to the federal SALT cap, so confirm your state’s current-year rules and election deadline instead of relying on assumptions. Second, an early version of OBBBA would have denied the PTET deduction to service businesses; the enacted law did not, so the workaround remains available across business types.
California is the case worth knowing in detail, both because so many readers are there and because its mechanics changed. The elective tax was originally scheduled to expire after the 2025 tax year; once OBBBA extended the federal cap, SB 132 (signed June 27, 2025) extended the California election in step, to tax years beginning on or after January 1, 2026 and before January 1, 2031 — and wrote in an early termination if Congress repeals the federal cap first. The rate is 9.3% of the consenting owners’ distributive share, and the owners take a credit against their personal California tax. The election is annual and made on a timely-filed original return — but the operative deadline is earlier than the return. A prepayment is due by June 15 of the election year, equal to the greater of $1,000 or 50% of the prior year’s elective tax, with the balance due by the original return date.
The consequence of missing that June 15 payment is what changed. Through 2025, a late or short prepayment was an absolute bar — you simply lost the election for the year, with no cure. For 2026 onward, SB 132 replaced the cliff with a price: the election survives, but the credit the owners can claim is reduced by 12.5% of the underpaid amount. That is a real improvement and still not a reason to be casual — a missed prepayment on a large election costs meaningful money, and June 15 falls a month before most owners have thought about the year’s tax at all. Put it on the calendar in January.
The 2026 cap changes the arithmetic, and it cuts both ways. Below $505,000 of MAGI the $40,400 cap may already swallow your whole state bill: a California couple with $300,000 of pass-through income owes roughly $20,000 of state income tax, and with a $12,000 property-tax bill still fits under the cap with no election at all. Electing anyway buys nothing federally and leaves you holding a nonrefundable 9.3% credit that carries forward only five years ( R&TC §17052.10) — a real cost if your California marginal rate is below 9.3% or your income is lumpy. Inside the $505,000–$606,000 band the election earns its keep twice: the entity-level tax comes off the K-1 before it reaches your return, so it is deducted in full, and it lowers the MAGI the phaseout is measured against, which preserves the remaining cap for your property taxes. Above $606,000 you are back at a $10,000 cap and the election is as close to mandatory as it ever was. Model it every year against the current cap and your projected MAGI. Renewing last year’s election on autopilot was safe under a $10,000 cap; it is not safe under a moving one.
Where a PTET pays, electing in is one of the highest-return administrative steps available to a business owner. Nothing else on the compliance calendar converts a capped itemized deduction into an uncapped business deduction for the cost of one form and one payment date.