Pass-Through Entity Tax Elections: Federal and State Tax Coordination Under Current Law

By Jessica I. Marschall, CPA, December 6^th, 2025

Pass-Through Entity Tax (PTET) elections remain one of the most significant state tax planning mechanisms available to partnerships and S corporations following changes to federal itemized deduction limitations. Understanding how PTET operates at both the entity and individual level is essential for tax planning, particularly for high-income taxpayers in states with significant income tax rates.

The Origin and Purpose of PTET

PTET elections emerged as a response to the $10,000 limitation on state and local tax (SALT) deductions imposed by the Tax Cuts and Jobs Act of 2017. This limitation applies to individual taxpayers claiming itemized deductions on Schedule A of Form 1040, significantly affecting taxpayers in states with high income tax rates.

Because the SALT cap applies only to individuals and not to business entities, states began enacting legislation allowing pass-through entities to elect entity-level taxation. Under these regimes, partnerships and S corporations pay state income tax directly at the entity level rather than passing the tax liability through to partners or shareholders.

The entity-level payment generates a federal business deduction under Section 164, reducing the entity’s ordinary business income. This deduction flows through to owners on Schedule K-1, reducing their federal taxable income without being subject to the individual SALT cap limitation.

How PTET Functions at the Entity Level

When a partnership or S corporation elects PTET:

1. The entity calculates its state-source income subject to state taxation
2. The entity pays state income tax directly to the applicable state
3. The state tax payment is deducted as an ordinary business expense on the entity’s federal return (Form 1065 for partnerships, Form 1120-S for S corporations)
4. This deduction reduces the entity’s ordinary business income
5. The reduced income flows through to partners or shareholders on their respective Schedule K-1

The federal deduction is not limited by the SALT cap because it occurs at the entity level as a business expense, not at the individual level as an itemized deduction.

Impact on Individual Federal Returns

PTET elections affect individual taxpayers in several ways:

Reduced Flow-Through Income

The entity’s payment of PTET reduces ordinary business income reported on Schedule K-1. Partners report this reduced income on Schedule E of Form 1040. Lower Schedule E income reduces adjusted gross income (AGI) and consequently reduces federal income tax liability.

SALT Cap Avoidance

The federal deduction for PTET occurs at the entity level and is not subject to the $10,000 SALT deduction limitation applicable to individual itemized deductions. Taxpayers benefit from the full deduction regardless of their personal state tax payments or itemized deduction amounts.

Effects on AGI-Dependent Provisions

Lower AGI affects numerous tax provisions including:

• Qualified Business Income (QBI) deduction under Section 199A
• Net Investment Income Tax (NIIT) under Section 1411 (3.8% surtax on investment income)
• Medicare premium surcharges (IRMAA thresholds)
• Passive activity loss limitations under Section 469
• Various credit phaseouts

Strategic use of PTET can position taxpayers below critical AGI thresholds for these provisions.

Treatment on State Returns

States providing PTET elections typically implement one of the following mechanisms to prevent double taxation of the same income:

1. Refundable or nonrefundable tax credit equal to the proportionate share of PTET paid by the entity
2. Exclusion or subtraction adjustment reducing state taxable income by the amount already taxed at the entity level
3. Combination approach using both credits and income adjustments

The individual taxpayer reports the full amount of pass-through income but receives a corresponding credit or adjustment, effectively eliminating or substantially reducing personal state income tax liability on that income.

States With Significant PTET Provisions

The following states have enacted PTET elections particularly relevant for high-income taxpayers:

California – 13.3% top rate; mandatory election for qualified entities above $1 million in income; significant federal tax savings for affected taxpayers

New York – 10.9% top rate (NYC residents face additional 3.876% city tax); elective regime; substantial benefit for NYC-based professionals and business owners

New Jersey – 10.75% top rate; elective regime with favorable credit mechanism; particularly valuable for financial services and pharmaceutical industry participants

Connecticut – 6.99% top rate; elective regime; commonly used by hedge funds and private equity partnerships

Maryland – 5.75% state rate plus local rates up to 3.2%; elective regime; significant for DC metro area businesses

Virginia – 5.75% flat rate; elective regime; increasingly used by Northern Virginia technology and government contractor firms

Massachusetts – 9.0% rate (5.0% base plus 4.0% surtax on income over $1 million); elective regime; valuable for professional service firms and real estate partnerships

Minnesota – 9.85% top rate; elective regime; benefits medical practices, law firms, and family-owned businesses

Illinois – 4.95% flat rate; while the rate is lower, PTET remains valuable for high-income earners subject to the SALT cap

Wisconsin – 7.65% top rate; elective regime with broad application

These states represent jurisdictions where PTET elections generate measurable federal tax savings due to the combination of high state tax rates and significant pass-through business activity.

Qualification and Election Requirements

PTET elections typically require:

• Annual election by specified deadlines (often before the close of the tax year or early in the following year)
• Entity-level determination of who may make the election (partners, members, shareholders, or managers)
• Minimum income thresholds in some states
• Estimated payment requirements during the tax year
• Formal election filing with state tax authorities

Requirements vary significantly by state. Some states impose mandatory PTET above certain income levels, while others treat it as an annual elective provision.

Federal Deduction Timing

The federal deduction for PTET follows ordinary and necessary business expense principles under Section 162. The deduction is taken in the year the tax is paid, consistent with the cash method of accounting used by most pass-through entities for state tax payments.

For calendar year entities, PTET paid in the fourth quarter or early in the following year (if permitted by state law as a prior-year payment) may generate timing advantages by accelerating the federal deduction.

Interaction With Qualified Business Income Deduction

The Section 199A deduction permits eligible taxpayers to deduct up to 20% of qualified business income (QBI) from qualified trades or businesses. PTET payments reduce QBI because they reduce the entity’s ordinary business income before it flows through to owners.

However, the net federal benefit typically favors PTET election despite the QBI reduction. The full federal deduction for PTET (at ordinary income rates up to 37%) generally exceeds the reduction in QBI deduction (20% of the PTET amount, effectively 7.4% at the top rate).

For taxpayers subject to W-2 wage and property limitations on the QBI deduction, the interaction becomes more complex and requires year-specific modeling.

Net Investment Income Tax Considerations

The 3.8% NIIT applies to the lesser of (1) net investment income or (2) the excess of modified adjusted gross income over threshold amounts ($200,000 for single filers, $250,000 for married filing jointly).

PTET reduces AGI, which may reduce or eliminate NIIT exposure for taxpayers near the threshold amounts. This creates an additional federal benefit beyond the ordinary income tax savings.

Multi-State Considerations

Partnerships and S corporations operating in multiple states face complex PTET planning. Each state’s PTET election operates independently. An entity may elect PTET in some states but not others based on:

• State income tax rates
• Apportionment formulas
• Owner residence states
• Credit availability in owner residence states for taxes paid to source states

Owners residing in states that do not allow credits for PTET paid to other states may face state-level double taxation, reducing or eliminating the benefit of PTET in the source state.

Planning Considerations

Effective PTET planning requires:

1. Annual election analysis – PTET benefit varies based on entity income, owner income levels, and changes in federal and state tax law
2. Estimated payment compliance – Late or insufficient payments may result in penalties
3. Owner communication – Owners must understand the state tax credit mechanism to properly file their individual returns
4. Multi-state coordination – Entities with operations in multiple states require state-by-state analysis
5. QBI and NIIT modeling – Year-specific calculations determine whether PTET maximizes total tax savings

Comparison to C Corporation Treatment

Some taxpayers consider converting pass-through entities to C corporations to access the 21% corporate tax rate. However, C corporation treatment creates double taxation: once at the entity level and again when dividends are distributed to shareholders.

PTET provides a middle ground, allowing pass-through entities to achieve entity-level deductions similar to C corporations while preserving single-level taxation on distributed income.

Recent Developments

IRS Notice 2020-75 confirmed that the IRS will not challenge the federal deductibility of state taxes paid under PTET regimes. This notice resolved uncertainty about whether the IRS would recharacterize PTET payments as nondeductible individual taxes.

Subsequently, the IRS issued final regulations under Section 162 affirming that PTET payments constitute ordinary and necessary business expenses deductible in full without regard to the SALT cap.

These pronouncements provide certainty for taxpayers making PTET elections.

Who Benefits Most From PTET

PTET elections generate the greatest federal tax benefit for:

• High-income pass-through business owners with substantial state tax liability
• Owners in states with top marginal rates exceeding 5%
• Taxpayers who would otherwise be limited by the $10,000 SALT cap
• Taxpayers near AGI thresholds for NIIT, QBI limitations, or credit phaseouts
• Professional service partnerships (law firms, medical practices, consulting firms) in high-tax states
• Real estate partnerships with significant income allocated to high-income partners

PTET provides limited benefit for:

• Taxpayers with income below the standard deduction
• Pass-through entities operating in states without income tax (Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, Wyoming)
• Entities with net losses for state tax purposes
• Owners whose state of residence does not provide credits for PTET paid to other states

Administrative Requirements

Entities electing PTET must:

• File annual PTET elections by state-specified deadlines
• Make quarterly estimated payments in most states
• Maintain records supporting state-source income calculations
• Provide Schedule K-1 recipients with information necessary to claim state credits
• File entity-level state income tax returns reporting PTET liability
• Track basis adjustments for partners or shareholders

Failure to comply with administrative requirements may result in disallowed deductions, penalties, or loss of PTET benefits.

Conclusion

PTET elections remain a critical tax planning tool for pass-through entities and their owners. The ability to deduct state income taxes in full at the entity level, bypassing the individual SALT cap, generates substantial federal tax savings for affected taxpayers.

As states continue refining PTET regimes and federal tax law evolves, annual analysis of PTET elections remains necessary. The interaction with QBI deductions, NIIT, and state credit mechanisms requires careful modeling to ensure PTET elections maximize after-tax returns.

For partnerships and S corporations operating in states with PTET provisions, election should be evaluated each year as part of comprehensive tax planning.