Pass-Through Entity Tax 2026: SALT Cap Workaround Guide
The pass through entity tax is one of the most consequential state-and-local tax planning tools of the last decade. Enabled by IRS Notice 2020-75 and now adopted by more than three dozen states, it lets a partnership or S corporation pay state income tax at the entity level and take that payment as a fully deductible federal expense — sidestepping the individual owner’s federal SALT deduction cap under IRC §164(b)(6).
At SW Accounting & Consulting Corp, we work with California and multistate pass-through businesses that have been running annual PTET elections since the workaround emerged. In 2026 the map is largely settled — but the elections are no longer easy calls, and the higher SALT cap in the One Big Beautiful Bill Act (P.L. 119-21) has changed the math for a lot of owners. Here is how the planning framework looks now.
What is the pass through entity tax, and why did states create it? 🧾
PTET is a state-level election that shifts a share of an owner’s state income tax up to the entity, converting a capped individual SALT deduction into a fully deductible federal business expense.
The 2017 Tax Cuts and Jobs Act capped the federal itemized deduction for state and local taxes at $10,000 per return under IRC §164(b)(6). For high-income owners in states like California, New York, and New Jersey, that cap wiped out most of the federal benefit of their state tax bill.
States responded by creating an optional entity-level tax on pass-through income. The partnership or S corporation pays the tax; the state gives the owner a credit or exclusion; and — critically — the entity deducts the payment above the line. In Notice 2020-75, the IRS confirmed that specified income tax payments made by a partnership or S corporation are deductible in computing the entity’s non-separately stated income, and are not subject to the owner-level SALT cap. That single piece of federal guidance is why PTET exists as we know it.
Did the 2025 SALT cap change kill the pass through entity tax? 🔍
No. The One Big Beautiful Bill Act raised the SALT cap for many taxpayers, but the entity-level PTET deduction is still worth more than the itemized deduction for owners with meaningful state tax liability.
The OBBBA (P.L. 119-21), enacted in July 2025, temporarily raised the federal SALT deduction cap above the $10,000 TCJA level and phased that increase down for high-income taxpayers. For some owners with modest state tax bills — a low-earning shareholder or a partner in a low-tax state — the higher cap may absorb their full state tax liability and eliminate any incremental PTET benefit.
For most profitable pass-through owners in California and other high-tax jurisdictions, the PTET election still leaves meaningful state tax dollars on the wrong side of the individual cap. In those cases the entity-level deduction remains the more valuable path. The change is not that PTET is obsolete — it is that the answer now varies more by owner, so a one-size election run out of habit is more likely to be wrong than it used to be.
Why is the pass through entity tax election really an owner-level decision? 👥
The election is made by the entity, but the economics are almost always determined at the owner level — especially when owners live in different states or have different income mixes.
A single PTET election can produce very different results for different owners of the same business. The most common owner-level variables:
- Residency and resident credit mechanics. If a non-resident owner’s home state grants a full, usable credit for PTET paid to another state, the election preserves the federal benefit. If that credit is limited, mistimed, or unavailable, the owner can end up double-paying state tax and losing part of the anticipated benefit.
- Ownership structure. Tiered partnerships, trusts, corporate owners, and special allocations complicate whether the PTET deduction and credit reach the ultimate individual owners cleanly.
- Mixed profiles. An S corporation with three shareholders — two California residents, one Nevada resident — may see the two Californians benefit while the Nevadan bears state tax on income they never had before.
- Withholding and composite return interaction. Many states run withholding or composite return regimes for non-residents. Layering a PTET election on top can help or hurt depending on how the state coordinates the mechanisms.
The takeaway: the election is entity-level in form and owner-level in substance. Modeling it as a simple entity decision — the way many closely held businesses still do — is how the federal deduction quietly turns into a state-level inefficiency.
What should a business do before making the PTET election in 2026? ✅
Treat PTET as an annual planning exercise: confirm eligibility, model owner-by-owner, watch deadlines, and coordinate estimated payments and K-1 reporting.
A practical checklist for the 2026 filing cycle:
- Confirm entity eligibility. Not every entity type qualifies in every state. Some regimes exclude publicly traded partnerships, disregarded entities, or entities with certain owner classes.
- Model owner-by-owner, not just entity-wide. Run the federal deduction gain net of any resident-credit shortfall for each owner. If the aggregate benefit is small once losers are netted against winners, the election may not be worth its administrative cost.
- Check the election deadline and revocability rules. State PTET regimes differ sharply on when the election is made, whether it binds the entity for a year or longer, and whether estimated payments must accompany the election.
- Coordinate estimated payments. A missed or underpaid PTET estimate can disqualify the election or trigger state penalties, and can distort the owner’s own quarterly tax planning.
- Communicate credits and K-1 amounts to owners. Owners need to know their share of the PTET credit before they file. Late or incomplete communication is one of the leading sources of amended returns in this area.
- Re-check federal tax profile after the OBBBA. If an owner’s state tax liability now fits under the higher OBBBA SALT cap, the incremental federal benefit of PTET may be smaller than it was in prior years.
PTET decision framework at a glance 📊
| Owner profile | PTET typically… | Watch item |
|---|---|---|
| High-income resident of high-tax state | Still valuable | Confirm election deadline and estimate mechanics |
| Non-resident of state where entity operates | Depends on resident-state credit | Model resident credit before electing |
| Modest-income owner post-OBBBA | Marginal or neutral | Higher SALT cap may absorb state liability |
| Tiered partnership / trust owner | Complex; case-by-case | Trace credit flow to ultimate owner |
📌 Key Takeaways
- PTET exists because IRS Notice 2020-75 confirmed the entity-level deduction is not subject to the individual SALT cap.
- The OBBBA raised the SALT cap in 2025 but did not eliminate PTET’s value for most profitable pass-throughs.
- The election is owner-level in substance — residency and resident credits often decide the answer.
- Re-model every year. A prior-year election is a data point, not a decision.
Frequently Asked Questions ❓
Q. What is the pass through entity tax in one sentence?
It is an optional state-level tax on the income of a partnership or S corporation that lets the entity deduct the payment federally, converting what would otherwise be a capped individual SALT deduction into a full business expense.
Q. Where does the federal deductibility come from?
From IRS Notice 2020-75, which confirmed that specified income tax payments made by a partnership or S corporation are deductible in computing the entity’s non-separately stated income and are not subject to the owner-level SALT limitation under IRC §164(b)(6).
Q. Did the 2025 OBBBA repeal the SALT cap?
No. The One Big Beautiful Bill Act (P.L. 119-21) raised the SALT deduction cap above the prior $10,000 level and phased that increase down for high-income taxpayers, but the SALT cap itself is still in place.
Q. Should every pass through elect PTET now?
No. The election must be re-evaluated annually. For high-income owners in high-tax states it is usually still favorable; for smaller pass-throughs whose owners can now absorb their state tax under the higher OBBBA cap, the incremental benefit may be small or zero.
Q. What is the biggest planning risk with PTET?
Non-resident owners whose home state’s resident credit does not fully absorb the PTET paid to the electing state. That mismatch can leave part of the state tax uncredited and reduce or eliminate the intended federal benefit.
Q. How should California owners think about PTET after the OBBBA?
California residents with meaningful pass-through income generally still benefit from the California PTET election, but the size of the benefit now depends on where each owner lands under the OBBBA’s higher SALT cap and phase-out. Model each owner, not just the entity.
If you would like an owner-by-owner PTET model for your entity before the 2026 election deadline, contact SW Accounting & Consulting Corp. Primary sources: IRS Notice 2020-75, IRC §164, and the One Big Beautiful Bill Act (P.L. 119-21).
