The Pass-Through Entity Tax (PTET) is an entity-level income tax that business owners can elect to take to deduct their state taxes as a business expense and circumvent the $10,000 SALT cap.
In 2017, the Tax Cuts and Jobs Act (TCJA) was passed, becoming the largest tax overhaul in modern history. One controversial aspect of the TCJA was the capping of the State and Local Tax (SALT) deduction at $10,000. Additionally, the standard deduction doubled. In 2024, for example, it’s $14,600 for individuals and $29,200 for joint filers. This means that even if you have $10,000 in state and local taxes, you cannot deduct them unless you itemize your returns.
Historically, state and local taxes were a significant deduction for reducing federal tax liability, especially in high-tax states. However, now, this option is limited unless you itemize, which the majority of taxpayers don’t. And even if you do itemize, you’re restricted to a $10,000 deduction.
The Workaround: Introducing the Pass-Through Entity Tax Election (PTET)
If you’re a business owner, you’re in luck. Through the Pass-Through Entity Tax Election, you can deduct all your state taxes on your federal tax return.
What is PTET?
When the TCJA imposed the 10k SALT deduction limit, states with high taxes, like California, were outraged. Their taxpayers faced significantly higher federal tax bills. As a workaround, the Pass-Through Entity Tax Election was created. PTET is an elective tax that business owners pay at the entity level. Instead of business income passing through to their individual return, they pay a separate state tax on their business income. This pass-through entity tax is 100% deductible at the federal level, and generally, you receive a dollar-for-dollar credit on your personal state tax return.
For example, if you elect PTET and the tax is $20,000, that amount is fully deductible on your federal return. It is not capped at $10,000, and you can still take the standard deduction. This $20,000 PTET then generally reduces any state tax you owe. For example, if your state tax liability is $20,000, it would be eliminated since you’ve already paid $20,000 through PTET.
Considerations:
- Not all states offer PTET, and each state’s rules vary. For example, in Arizona, the PTET tax is 2.5%, the same as the personal income tax rate. In California, it’s a flat 9.3%. You’ll need to work with your tax planner to see if the PTET is worth it.
- PTET reduces your Qualified Business Income (QBI), which may affect your QBI deduction.
- PTET can in some cases result in higher state taxes.
- PTET taxes must be paid separately, often through state online portals. These taxes cannot be deferred until the tax filing deadline of the following year and are not covered by quarterly tax payments or withholdings.
California Case Study:
We examine a solo business owner with a joint return and $900,000 in net income. Without the PTET, their total tax liability is higher. However, by electing to pay California’s 9.3% PTET on their net profits, they incur more state taxes but significantly reduce their federal taxable income, which drives down their overall tax liability. In this example, the business owner saves $25,702 in taxes.
Bottom Line
If you’re a business owner, even with a side hustle, this is something to consider. Please be advised this article is just merely scratching the surface. Considerations such as the state you file in, entity structure and more are all going to factor into how much PTET you should pay, if any. It’s a complex topic requiring advanced tax planning, so consult with your trusted financial and tax planner. If you don’t have one, set up a complimentary discovery call so we can learn more about you and your needs.
Important Disclosures
MDRN Wealth LLC does not provide specific legal or tax advice. Please consult with professionals in these areas for specific legal and tax recommendations. The information provided herein is general information. It is not intended to be construed as investment, tax, or legal advice. Information in this article is not an offer or solicitation to purchase, sell, or endorse a specific company, security, investment vehicle or strategy. Investing involves risk and the possible chance for loss of principal. Please consider your tolerance for risk before investing. Past performance is never guaranteed and future results can vary. Opinions conveyed by MDRN Wealth LLC cannot be viewed as an indicator of future performance and are subject to change. Results may vary. Use information at your own risk.
