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How do state pass-through entity taxes work?
How do state pass-through entity taxes work?

A major revenue raiser from the 2017 Tax Cuts and Jobs Act was the $10,000 cap on the state and local tax (SALT) deduction. Because the cap applies to personal income taxes but not business income taxes, many states have enacted entity-level taxes on pass-through businesses, which can deduct that tax fully on their federal returns.

Prior to 2018, taxpayers who itemized when filing their federal taxes could deduct state and local taxes (SALT) paid. The 2017 Tax Cuts and Jobs Act restricted that deduction, capping it at $10,000 per household while substantially raising the standard deduction. For some households, particularly wealthier ones in high-tax jurisdictions, the higher standard deduction did not provide the same amount of tax relief as the uncapped SALT deduction.

States considered a variety of workarounds to the SALT deduction cap to address this issue. Some proposed establishing state-run charitable funds that taxpayers could donate to and receive offsetting credits. Others suggested partially replacing state income taxes with employer payroll taxes that would remain deductible under the new. The IRS and Treasury rejected these proposals or the proposals proved unworkable, and state policymakers began turning to pass-through business entity taxes instead.

Business income from pass-throughs is generally not taxed at the entity level. Instead, the company’s owners pay tax on that income through their own individual returns. Because the SALT cap applies to individual income, individual owners of pass-through companies lost access to the full deduction. But C corporations, which face entity level taxes, could still access the full SALT deduction.

Connecticut, New York, and several other states responded by enacting pass-through entity (PTE) taxes. Owners of businesses subject to PTE taxes receive an offsetting income tax credit, so their combined individual and business-level state tax bill stays the same, but they can benefit from the full federal SALT deduction for PTE taxes paid. Treasury authorized PTE taxes in late 2020, prompting a flurry of PTE tax proposals across the country.

Currently, more than 30 states use PTE taxes. The taxes provide federal tax relief and equalize the tax treatment of corporate and pass-through business income, but they also create inequities between individual income earned from a pass-through businesses versus regular wages. The taxes have also complicated state income tax forecasting, and they lead to a sizeable revenue loss for the federal government.

Updated January 2024
Further reading

Dadayan, Lucy, and John Buhl. 2023. “Understanding Revenue Implications for State Pass-Through-Entity Taxes.” TaxVox (blog). Washington, DC: Urban-Brookings Tax Policy Center.

Rueben, Kim. 2021. “State Pass-Through Entity Taxes Let Some Residents Avoid the SALT Cap at No Cost to the States.” TaxVox (blog). Washington, DC: Urban-Brookings Tax Policy Center.

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