Understanding Pass-Through Entity (PTE) Elective Tax

The Pass-Through Entity (PTE) elective tax is one of the most valuable tax planning opportunities available to many pass-through business owners today. If you operate through a partnership, S corporation, or multi-member LLC, this option could reduce your federal tax bill by allowing your business to pay state tax at the entity level.

What Is the PTE Elective Tax?

Traditionally, pass-through entities do not pay income tax at the business level; profits pass through to owners, who pay tax on their personal returns. The PTE elective tax allows qualifying entities to elect annually to pay an entity-level state tax on income for taxable years beginning on or after January 1, 2021.

Why Was This Created? The SALT Cap Problem

The Tax Cuts and Jobs Act (TCJA) capped the state and local tax (SALT) deduction at $10,000 on individual returns, limiting deductions for many owners in high-tax states. C corporations, which pay tax at the entity level, were unaffected. States responded by creating PTE taxes so pass-through businesses could regain a federal deduction through entity-level payments.

How It Works

Paying state tax at the entity level converts what would be a limited personal SALT deduction into a fully deductible business expense for federal purposes. The basic flow:

1. Elect: Your business elects to pay the PTE tax instead of owners paying state tax personally on their shares of income.

2. Deduct: The entity deducts the payment on its federal return, potentially bypassing the $10,000 SALT cap for individual owners.

3. Credit: Owners receive a dollar-for-dollar credit on their state returns for their shares of tax paid by the business.

Who Qualifies?

• Partnerships (including LLCs taxed as partnerships)

• S corporations

• Multi-member LLCs

Specific qualifications vary by state and may include filing and payment requirements, eligible income rules, and partner/shareholder eligibility.

State-by-State Variations

• California: Elective tax rate of 9.3% on qualified net income. Estimated payments generally due June 15 and March 15 of the following year.

• Virginia: Electing PTEs taxed at 5.75%.

• New York: Optional PTET for partnerships and New York S corporations on certain income.

The Election Process

A qualified entity must make the election on its original, timely filed return. Most states require annual elections. Late or amended elections are typically not allowed, so planning ahead is essential.

Real-World Example (California)

Assume your share of business income is $200,000.

Without PTE Election:

• You pay California tax personally: $18,600 (9.3%)

• Federal SALT deduction limited to $10,000

• Remaining $8,600 provides no federal benefit

With PTE Election:

• Business pays $18,600 California PTE tax

• Business deducts full $18,600 on its federal return

• You receive an $18,600 credit on your California return

• Potential federal tax savings: $18,600 × your marginal tax rate (often $4,000+)

Important Considerations

Timing and Cash Flow

States like California require two payments: Voucher 1 due June 15 and Voucher 2 due March 15 of the following year. Ensure the business has sufficient cash flow.

Estimated Tax Penalties

Some states (e.g., Hawaii starting in 2024) may assess penalties for underpayment of estimated taxes.

Future Uncertainty

Many PTE provisions apply to tax years beginning on or after January 1, 2021 and before January 1, 2026, unless extended.

Legislative Changes on the Horizon

Congress continues to discuss SALT changes. Some proposals could affect the benefit of entity-level taxes that work around the SALT cap. Proactive planning is key.

Should You Elect PTE Tax?

The decision depends on:

• Your federal and state effective tax rates

• Your business's cash flow and payment timing

• Whether you already hit the $10,000 SALT cap

• Your state's specific PTE rules and credit mechanics

Generally, owners in high-tax states who already max out the SALT deduction often benefit from making the election.