Is PTE Tax Deductible on a Federal Return?

A Pass-Through Entity (PTE) tax is a levy imposed by a state directly on the income of businesses like partnerships and S corporations. This tax is deductible on a federal return, but the deduction is taken by the business entity itself, not by the individual owners on their personal tax returns. This structure is a strategic state-level response to a significant federal tax law change.

The core of this strategy involves shifting the payment of state income tax from the individual to the business. By doing this, the tax payment is recharacterized for federal purposes, unlocking a deduction that would otherwise be limited for the individual owner. The result is a lower federal tax bill for the business owners.

The SALT Cap Workaround Explained

To understand the purpose of PTE taxes, one must first understand the federal deduction for state and local taxes, commonly known as the SALT deduction. For decades, individuals who itemized deductions on their federal tax returns could deduct the full amount of state and local taxes they paid, including income, property, and sales taxes. This provided significant tax relief, particularly for taxpayers residing in states with high tax rates.

This long-standing benefit was altered by the Tax Cuts and Jobs Act of 2017 (TCJA). The TCJA introduced a restrictive rule: the total amount an individual or married couple can deduct for state and local taxes is now capped at $10,000 per household per year. This “SALT cap” created a substantial new federal tax burden for many owners of pass-through businesses, as their business income is taxed at their individual rates and was previously offset by a full SALT deduction.

In response to the financial pressure the SALT cap placed on residents, numerous states developed a solution. They created an elective PTE tax, a system that allows a pass-through business to choose to pay state income tax at the entity level. The logic is that the $10,000 SALT cap applies to individuals, but it does not apply to taxes paid by a business. By shifting the legal responsibility for the tax payment from the individual owner to the business entity, the payment becomes a business expense, effectively bypassing the individual’s $10,000 limitation.

How the Federal Deduction Works for the Business

The IRS clarified its position on these payments in Notice 2020-75. This guidance confirmed that state and local income taxes paid by a partnership or an S corporation are an allowable deduction by the business in computing its non-separately stated income or loss. This means the PTE tax payment is treated as an ordinary and necessary business expense.

The business deducts the entire amount of the state tax paid on its federal income tax return. This treatment is available for businesses using either the cash or accrual method of accounting. Cash-basis businesses deduct the tax in the year it is paid, while accrual-basis businesses generally deduct it in the year it was incurred.

The direct effect of this deduction is a reduction in the business’s net income for federal tax purposes. For example, if a business has $1,000,000 in income and pays $90,000 in state PTE tax, its federally taxable income is reduced to $910,000. This reduction occurs before any income is allocated to the individual owners.

Impact on the Individual Owner’s Federal Return

The federal deduction taken by the business has a direct and beneficial impact on the individual owner’s federal tax return. Because the business has already deducted the state PTE tax, the net income that “passes through” to the owners is lower. This reduced income figure is reported to each owner on their Schedule K-1.

This directly translates to less taxable income and, therefore, a lower federal income tax liability for the owner. The owner benefits from the full state tax deduction, just as they would have before the SALT cap, but the benefit is realized through reduced business income rather than a personal itemized deduction.

To prevent double taxation, states that have implemented a PTE tax also provide a corresponding benefit to the owner on their state personal income tax return. Typically, the owner is allowed to claim a tax credit or an income exclusion for their share of the PTE tax paid by the business.

Reporting and Practical Application

On the business’s federal return, either Form 1065 for a partnership or Form 1120-S for an S corporation, the PTE tax paid is not listed on its own unique line. Instead, it is typically aggregated with other similar expenses and included in the total deduction for “Taxes and licenses.”

For the individual owner, the primary evidence of the PTE tax deduction appears on their Schedule K-1. The impact is seen in Box 1, “Ordinary business income (loss),” which will be a lower number than it would have been without the PTE tax deduction. The K-1 may also include a statement or a footnote in Box 14 for partnerships or Box 12 for S-corporations, detailing the amount of the state tax credit available to the owner for use on their state return.

Finally, this information flows directly to the owner’s personal Form 1040. The reduced ordinary business income from the K-1 is carried over to Schedule E. This, in turn, lowers the owner’s adjusted gross income (AGI) on the front page of their Form 1040. The result is a tangible reduction in the owner’s federal tax liability, achieved by converting a limited individual deduction into an unlimited business expense.