Is Pass-Through Entity Tax Deductible on a Federal Return?

Understanding the federal deductibility of state-level pass-through entity (PTE) taxes is a relevant topic for many business owners. Pass-through entities represent a common business structure in the United States, and recent developments at the state level have introduced new considerations for their tax treatment. This article aims to clarify how these state-imposed PTE taxes interact with federal income tax regulations, particularly concerning their deductibility. This exploration will cover the nature of pass-through entities, the federal limitations on state and local tax deductions, and the specific mechanisms that allow these state PTE taxes to be deductible on federal income tax returns.

Understanding Pass-Through Entities and Their Taxes

Pass-through entities are business structures where profits and losses “pass through” directly to the owners’ personal income tax returns, meaning the business itself does not pay federal income tax; common examples include S corporations, partnerships, and limited liability companies (LLCs) that elect to be taxed as either partnerships or sole proprietorships. The income, deductions, and credits of these entities are reported on the individual tax returns of the owners, and taxes are paid at the individual income tax rates. This structure avoids the “double taxation” typically associated with C corporations, where corporate profits are taxed at the entity level and then again when distributed to shareholders as dividends. In recent years, states have begun implementing entity-level taxes specifically targeting these pass-through businesses. These state-level PTE taxes emerged as a response to changes in federal tax law, allowing states to provide a pathway for their resident business owners to gain a federal tax benefit.

The Federal Deduction for State and Local Taxes

The Tax Cuts and Jobs Act (TCJA) of 2017 introduced a significant change to how individual taxpayers can deduct state and local taxes (SALT) on their federal income tax returns, imposing a $10,000 cap on the total amount of state and local income, sales, and property taxes that an individual can deduct. For married individuals filing separately, the cap is $5,000. This limitation applies to tax years 2018 through 2025. Before this cap, there was no direct limit on the amount of state and local taxes that could be deducted by itemizing taxpayers. The $10,000 cap significantly impacts taxpayers in areas with high state and local tax burdens, as they may pay far more than this amount in taxes but can only deduct a limited portion.

How Pass-Through Entity Taxes Are Federally Deductible

State-level pass-through entity taxes are deductible for federal income tax purposes primarily due to guidance issued by the Internal Revenue Service (IRS). The IRS clarified in Notice 2020-75 that it would allow a deduction for certain state and local income taxes paid by a partnership or S corporation at the entity level. These payments, referred to as specified income tax payments, are deductible by the pass-through entity itself as an ordinary and necessary business expense. This entity-level deduction is significant because it effectively bypasses the $10,000 individual SALT cap.

When the PTE pays the state tax, the entity’s taxable income is reduced by that amount before it is passed through to the owners. Consequently, the income reported on the owners’ individual federal tax returns (via Schedule K-1) is already net of the state PTE tax, leading to a lower federal taxable income for the individual. This mechanism provides a federal tax benefit to the owners of pass-through entities. The deduction is taken at the entity level, meaning it is not subject to the individual taxpayer’s itemized deduction limitations. This approach has led many states to enact their own PTE tax regimes, seeking to provide tax relief to their resident business owners.

Key Considerations for PTE Tax Deductibility

The landscape of state-level pass-through entity taxes is diverse, and their implementation varies across jurisdictions. Not all states have adopted a PTE tax, and those that have may differ in their specific rules and requirements. The effectiveness and structure of these taxes can depend on whether the state’s PTE tax is mandatory or an elective choice for the entity. For entities and their owners, understanding the specific eligibility criteria in their state is important.

Most states that have enacted PTE taxes allow the owners of the entity to receive a credit against their individual state income tax for their share of the tax paid at the entity level. This credit ensures that the income is not double-taxed at the state level, as it has already been subject to tax at the entity level. The entity-level deduction directly reduces the distributive share of income passed through to individual owners. This reduction lowers their federal taxable income, providing a benefit that would otherwise be constrained by the individual SALT deduction cap. Eligibility often hinges on the type of pass-through entity and may sometimes involve specific income thresholds or business activities.

Reporting PTE Tax Deductions

Reporting pass-through entity tax deductions on federal tax forms involves the entity itself and its individual owners. The pass-through entity typically deducts the state PTE tax as an ordinary and necessary business expense on its federal income tax return. For partnerships and LLCs taxed as partnerships, this deduction is reported on Form 1065, U.S. Return of Partnership Income. S corporations will report this deduction on Form 1120-S, U.S. Income Tax Return for an S Corporation.

After the entity deducts the state PTE tax, the net income is then passed through to the individual owners. Each owner receives a Schedule K-1, a document detailing their share of the entity’s income, deductions, and credits. This K-1 will reflect their share of the entity’s income already reduced by the PTE tax.