Deducting Your State Income Taxes with a Pass-Through Entity

The personal federal income tax deduction for state and local income taxes and property taxes (SALT) is capped at $10,000 per year through 2025. So, if you live in a high-tax state like California or New York and owe $10,000 or more in property taxes, that tax alone will use up your $10,000 deduction. You'll get no federal deduction at all for the state income taxes you pay.

However, many states have adopted an optional pass-through entity (PTE) tax that effectively enables some business owners to deduct state income tax on their business income without limit.

Pass-Through Entity Tax

Again, some states have an optional PTE tax so business owners can deduct state income tax on their business income without facing the $10,000 limit. In these states, a PTE's owners can elect to have the PTE pay the state income tax due on the PTE's business income that would otherwise be paid on their personal tax returns. The PTE then claims a federal business expense deduction for the state income tax payments.

The $10,000 SALT cap doesn't apply to such payments from a business. The PTE's owners then get a state income tax credit for the state income tax the PTE paid or pay state income tax on the reduced amount of PTE income. The IRS has approved this arrangement. (IRS Notice 2022-75).

Example. ABC, LLC, is a two-member California LLC with $400,000 in net income. Both members make the PTE tax election, and the LLC pays a 9.3% PTE tax to California. This $37,200 payment is a deductible business expense by the LLC, reducing its net income to $362,800. Each LLC member reports $181,400 of net income ($362,800 × 50%) on their federal K-1, resulting in a $43,536 federal income tax bill. Without the PTE tax deduction, they would have had to pay $48,000. When the members file their individual California income tax returns, they each report $200,000 of net income from ABC, LLC, and take a tax credit of $18,600 against their individual California income tax. So, they pay no individual California income tax on their LLC income. Meanwhile, they each save $4,464 in federal income tax.

State PTE Taxes Are Only for Owners of PTEs

State PTE taxes are only for owners of PTEs: partnerships, limited partnerships, S corporations, and multimember LLCs. Sole proprietors and owners of single-member LLCs can't pay them.

States With PTE Taxes

PTE taxes have been enacted in the following states: Alabama, Arizona, Arkansas, California, Colorado, Connecticut, Georgia, Hawaii, Idaho, Illinois, Indiana, Iowa, Kansas, Kentucky, Louisiana, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Montana, Nebraska, New Jersey, New Mexico, New York, North Carolina, Ohio, Oklahoma, Oregon, Rhode Island, South Carolina, Utah, Virginia, West Virginia, and Wisconsin.

If you have a multiowner pass-through business in one of these states, check your state tax agency's website for information on its PTE tax. The tax rates and procedures for making the PTE tax election and paying the tax vary from state to state.

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For more information on this and other tax issues for small businesses, get Deduct It! Lower Your Small Business Taxes, by Stephen Fishman (Nolo).

If you need more help, talk to a tax professional, such as a certified public accountant or a tax attorney. A tax professional can prepare tax returns or provide tax information, guidance, or representation before the IRS.