Navigating the State and Local Tax (SALT) Deduction and Leveraging the Pass-Through Entity (PTE) Deduction for Business Owners

Introduction

The State and Local Tax (SALT) deduction has long been a significant tax benefit for individuals and business owners, especially those living in high-tax states. However, the Tax Cuts and Jobs Act (TCJA) passed in 2017 brought major changes by capping the SALT deduction at $10,000. This cap has greatly impacted many high-income earners and business owners, raising their overall tax liability. Fortunately, several states have introduced ways to help business owners reduce their taxes despite this cap, particularly through the Pass-Through Entity (PTE) deduction. This article will explain what the SALT deduction is, how it works, how the PTE deduction offers a potential solution, and what changes we might expect in the future.

What is the SALT Deduction?

The SALT deduction has been part of the U.S. tax system since 1913. It allows taxpayers to deduct the state and local taxes they pay—such as income, property, and sales taxes—on their federal tax return. This deduction helps to prevent “double taxation,” meaning you don’t have to pay both state and federal taxes on the same income.
Before 2017, this deduction was unlimited, which meant that people who paid large amounts of state and local taxes could deduct the full amount from their federal income. For people living in states with high taxes (such as California or New York), this deduction was extremely valuable.

The 2017 Tax Cuts and Jobs Act (TCJA) and the $10,000 Cap

The Tax Cuts and Jobs Act (TCJA) of 2017 introduced a significant change by capping the SALT deduction at $10,000. This means that no matter how much you pay in state and local taxes, you can only deduct up to $10,000 on your federal tax return.
This cap has disproportionately affected higher-income individuals, especially those living in states with high taxes. Before the cap, someone paying $20,000 or more in state and local taxes could deduct the full amount, reducing their federal tax bill. After the TCJA, that same taxpayer can only deduct $10,000, potentially increasing their federal tax bill by thousands of dollars.

How the SALT Cap Affects Business Owners

Business owners in high-tax states have been particularly affected by the SALT cap. This is because, as individuals, they are limited to the same $10,000 deduction for state and local taxes, even if their total tax bill is much higher due to their business income.
However, many states have found a solution to help business owners avoid the SALT cap through something called the Pass-Through Entity (PTE) deduction.

What is the PTE Deduction and How Does it Help?

The Pass-Through Entity (PTE) deduction allows business owners to bypass the SALT cap by having their business pay state and local taxes at the business entity level instead of on their personal tax return. When the business pays the taxes, those payments are considered a business expense, and business expenses are not subject to the $10,000 SALT cap.
Here’s how it works:
1. Entity-Level Taxation: In states that offer the PTE deduction, certain businesses, such as S-Corporations, LLCs, and partnerships, can choose to pay state and local taxes directly as a business.
2. Full Deduction: Because the taxes are paid by the business rather than the individual owner, the full amount of state and local taxes can be deducted as a business expense on the federal tax return. This bypasses the $10,000 SALT cap that applies to individuals.
By taking advantage of this deduction, business owners can reduce their federal tax bill in a way that wasn’t possible after the TCJA.

Which States Offer the PTE Deduction?

As of 2023, over 30 states have passed laws allowing pass-through businesses to elect to pay taxes at the entity level. High-tax states like California, New York, and New Jersey have implemented these rules, making it easier for business owners in these states to avoid the SALT cap.
Each state has its own specific rules and guidelines, so business owners should consult with a tax professional or advisor to ensure they are following the right procedures for their state.

Potential Future Changes to the SALT Deduction

The future of the SALT deduction cap is still uncertain, and there are several possibilities for how it could change in the coming years:
1. Repeal or Increase of the SALT Cap: There have been numerous efforts to repeal or raise the $10,000 SALT cap. Some lawmakers have proposed raising the cap, while others want to eliminate it altogether. If any of these changes were to pass, it could restore some or all of the tax benefits that were lost after the TCJA.
2. Expiration of the TCJA: The SALT cap is set to expire in 2025, along with other provisions of the TCJA. If Congress does not act to extend or modify these provisions, the full SALT deduction could be restored after 2025.
3. Expansion of PTE Deduction: More states are expected to adopt PTE deduction legislation in the coming years, and the strategy will likely gain further popularity as business owners look for ways to reduce their tax burden.

Conclusion

The SALT deduction cap introduced by the TCJA has significantly impacted many taxpayers, particularly business owners in high-tax states. However, the Pass-Through Entity (PTE) deduction offers a powerful workaround that allows business owners to avoid the $10,000 cap and fully deduct their state and local taxes.
While the future of the SALT cap is still uncertain, business owners should be aware of their options and work with their tax advisors to ensure they are taking full advantage of the tax-saving opportunities available to them. By understanding the SALT deduction, the PTE deduction, and potential future changes, business owners can optimize their tax strategies and minimize their overall tax liability.