Pass-Through Entity Tax: Definition and How It Works

A pass-through entity tax (PTET) — also called a state elective pass-through entity tax or entity-level tax election — is a state income tax imposed at the business entity level on the distributive income of pass-through owners, rather than collected from each owner individually on their personal return. As of 2026, 36 states and the District of Columbia have enacted PTET laws, all designed around IRS Notice 2020-75, which confirmed that entity-level state taxes are deductible by the business under IRC §164(a) without regard to the $10,000 SALT cap applicable to individuals.

How PTET Works

Under normal pass-through taxation, income from partnerships, S-Corps, and LLCs flows to each owner's individual return, where they pay state income tax on their share. Because the Tax Cuts and Jobs Act of 2017 (TCJA, P.L. 115-97) capped the individual deduction for state and local taxes at $10,000, owners in high-tax states lost the ability to deduct most of their state income tax on their federal return.

The PTET election inverts this structure:

  1. The entity elects into the PTET by filing the required state form by the jurisdiction's deadline (often the original return due date or an earlier election window).
  2. The entity pays state income tax on behalf of its owners — computed on the owners' allocable share of income — and deducts that payment as a business expense at the entity level under IRC §164(a)(3).
  3. The entity-level deduction flows through to owners as a reduction in their distributive share of income reported on Schedule K-1, effectively converting a capped individual deduction into an uncapped entity-level deduction.
  4. The state issues a tax credit to each owner equal to their share of the entity-level tax paid, which offsets the owner's individual state tax liability and prevents double taxation.

Example: An S-Corp owner has $500,000 of pass-through income. The state imposes a 10% individual income tax on that share. Without PTET, the owner can deduct only $10,000 of the $50,000 state tax liability on their federal return. With the PTET election, the entity pays the $50,000 tax, deducts it in full at the entity level, reducing the K-1 income to $450,000 — a $40,000 additional federal deduction worth approximately $14,800 at the 37% marginal rate.

OBBBA and the New $40,000 SALT Cap

The One Big Beautiful Bill Act (OBBBA, 2026) raised the individual SALT cap from $10,000 to $40,000 for taxpayers with modified AGI below $500,000. For clients whose total state and local taxes fall below $40,000, the PTET election may no longer provide incremental federal benefit. For clients above the $500,000 MAGI phase-out cliff — where the cap reverts to $10,000 — the election typically remains essential. See SALT Cap and PTET Elections After OBBBA for the income-band analysis.

Key Compliance Considerations

  • Election deadlines vary by state. Many states require the election by the original return due date of the entity return; some require election before the tax year begins. Missing the window forfeits the benefit for that year.
  • Not all states have PTET laws. Owners in non-PTET states cannot access this benefit. A handful of states that enacted PTET laws have enacted conformity with OBBBA and may be re-examining their programs.
  • QBI interaction. The entity-level PTET payment reduces the owner's allocable share of QBI, which can reduce the IRC §199A deduction. The net federal benefit requires modeling both the SALT cap savings and the QBI deduction reduction together. See the QBI deduction glossary entry for the §199A mechanics.
  • Estimated payments. Most states require PTET estimated payments on the entity's behalf, creating a cash flow obligation that does not exist under the individual payment model.

Related Terms

  • Pass-through entity — a business structure (partnership, S-Corp, LLC) where income flows directly to owners' individual returns rather than being taxed at the entity level. See Disregarded Entity vs Pass-Through Entity.
  • SALT cap — the $10,000 limit on the individual deduction for state and local taxes imposed by TCJA. See How to Use State PTE Tax Elections to Bypass the SALT Cap.
  • Schedule K-1 — the form through which a partnership or S-Corp reports each owner's allocable share of income, deductions, and credits, including the effect of the entity-level PTET payment.
  • QBI deduction — the IRC §199A deduction for qualified pass-through income, which interacts with the PTET election because the entity-level deduction reduces the owner's K-1 income.
  • Excess business loss — a limitation under IRC §461(l) on the deductibility of pass-through losses, a separate issue from PTET but often relevant in the same client engagement.

How CPAs Use PTET in Practice

CPAs serving S-Corp and partnership clients in high-tax states typically evaluate PTET eligibility annually as part of the entity's year-end tax planning. The core workflow is: (1) identify states where the entity has owners subject to state income tax; (2) model the net federal benefit after accounting for the QBI deduction reduction and the OBBBA SALT cap level; (3) confirm the state's election window and deadline; (4) compute required estimated payments; and (5) file the election and coordinate with the entity's payroll or tax calendar. For a detailed step-by-step process, see How to Use State Pass-Through Entity Tax Elections to Bypass the SALT Cap.

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