The pass-through entity tax, explained

The problem it solves: the SALT cap

Since 2018, individuals who itemize can deduct only a limited amount of state and local tax — income or sales tax plus property tax. The cap was $10,000 through 2024. The 2025 law raised it to $40,000, and for 2026 it's$40,400. But it shrinks by 30 cents for each dollar of income over $505,000, down to$10,000, and it goes back to $10,000 for everyone after 2029. A business owner in a high-tax state can easily pay more state tax than that.

How the workaround works

1. Your S corporation or partnership elects its state's pass-through entity tax.
2. The business pays state income tax on its profits, at the entity level.
3. It deducts that tax as a business expense. The IRS confirmed in 2020 that this is allowed — and it isn't subject to your personal cap, because the business, not you, paid it.
4. Your share of the profit is lower by the tax paid, so your federal taxable income is lower.
5. Your state gives you a credit — or an exclusion — for the tax the business paid, so you aren't taxed twice on the same income by the state.

The effect: state income tax on your business profit becomes a fully deductible business expense, instead of a capped personal one. The 2025 law considered ending this; the final version left it in place.

Who benefits most

• Owners in states with an income tax — the higher the rate, the bigger the saving.
• Anyone already at the cap from property tax and other state taxes.
• High earners in the phase-down, where the cap falls back toward $10,000.
• Owners who take the standard deduction — the business deducts the tax even though you don't itemize, so it's a deduction you wouldn't otherwise get at all.

The catch: every state is different

The federal side is settled. The state side isn't uniform. Each state decides whether it has a program, which businesses can elect, when the election is due and whether it can be undone, how estimated payments work, how much credit owners get, and how nonresident owners are treated. Some programs have deadlines early in the year or require payments by December 31 for that year's deduction. Check your state's revenue department — and your accountant — before the business elects.

Things to know before electing

• Only S corporations and partnerships, generally. A sole proprietorship or a single-owner LLC taxed as one usually can't use it — one more reason some owners elect S corporation status.
• Timing matters. The deduction goes in the year the business pays the tax.
• It lowers the QBI deduction a little, because it lowers the business's profit.
• Owners don't all benefit equally. In a business with several owners, those who don't itemize or live in other states may see it differently.

Whether your business should elect, and under which state's rules, is a question for your CPA or tax attorney.