Beyond the SALT Cap: A Deep Dive into PTE Tax Mechanics, History, and Hidden Traps

For decades, state income taxes were boring. Then came the Tax Cuts and Jobs Act (TCJA) of 2017, the $10,000 SALT Cap, and suddenly, paying state tax became the hottest topic in the industry.

We all know the basic pitch: "Pay the tax at the entity level to bypass the individual cap." But as we move past the initial rollout phase, the cracks in the pavement are starting to show. From the "Trade or Business" requirement to the timing of payments, the PTE election is not a one-size-fits-all deduction.

Here is a deep dive into the history, the mechanics, and the scenarios where this "perfect" loophole can actually backfire.

Part 1: How We Got Here (The History of Notice 2020-75)

When the $10,000 SALT cap hit in 2018, high-tax states (New York, Connecticut, California) panicked. They tried various workarounds, like recasting state taxes as "charitable contributions," which the IRS swiftly shut down.

Then, a few bold states (led by Connecticut and Wisconsin) tried a different approach: The Entity-Level Tax.

The theory was based on the text of the TCJA itself. The limitation applied to individuals (Section 164(b)(6)), but it did not apply to taxes paid by a trade or business (Section 162).

The IRS stayed silent until November 2020, when they issued Notice 2020-75. This was the "Golden Ticket." The IRS effectively announced: "If a state imposes a tax directly on the entity, we will respect it as a deduction in computing non-separately stated income, regardless of whether the payment is mandatory or elective."

This Notice opened the floodgates. Today, over 36 states have enacted PTE elections.

Part 2: The Character of the Deduction (Business vs. Investment)

This is where tax pros often get tripped up. The deductibility of the tax depends heavily on the activity of the entity.

Scenario A: The Operating Business (Section 162)

For an S Corp or Partnership engaged in an active trade or business (e.g., a dental practice, a manufacturing plant), the PTE tax is straightforward.

• Treatment: It is a "Trade or Business" expense under IRC § 162.

• The Result: It reduces "Ordinary Business Income" (Line 1 of the K-1).

• Self-Employment Tax: Because it reduces ordinary income, it effectively reduces the SE Tax (and Medicare Tax) base for active partners. This is the "Double Benefit."

Scenario B: The Investment Partnership (Section 212)

What if your client is a Family Office or an Investment Partnership that only holds marketable securities?

• The Problem: Normally, expenses for the production of income are IRC § 212 expenses. Under the TCJA, "miscellaneous itemized deductions" (including § 212 expenses) are disallowed for individuals.

• The PTE Magic: Notice 2020-75 defines "Specified Income Tax Payments" broadly. It states that these taxes are deductible in computing "non-separately stated income."

• The Trap: While the Federal rules seem to allow the deduction even for investment entities, many States prohibit investment partnerships from making the election in the first place.

• The Allocations: Even if the entity pays the tax, if the income is "Portfolio Income" (interest/dividends), the deduction usually cannot be netted against that income on the K-1. It often appears as an "Other Deduction," which might still be trapped as an investment expense depending on how the software flows it. Proceed with extreme caution here.

Scenario C: Rental Real Estate (Section 212 vs 162)

• Treatment: If the rental activity rises to the level of a Section 162 business, the tax is fully deductible against rental income.

• Passive Loss Issues: Remember, reducing the rental income with a PTE tax might increase a Passive Activity Loss (PAL). If the client has no other passive income to absorb the loss, you haven't saved them money; you've just created a larger carryover.

Part 3: Common Pitfalls and "Gotchas"

1. The Timing Trap (Accrual vs. Cash)

Notice 2020-75 uses the specific phrase: "Paid by a partnership or an S corporation."

Most conservative tax attorneys interpret this to mean that the PTE tax is only deductible in the year it is physically paid, regardless of whether the entity is Cash or Accrual basis.

• The Pitfall: A client accrues the state tax liability on December 31st but pays it on March 15th.

• The Result: The deduction is disallowed in Year 1 and pushed to Year 2. Best Practice: Always cut the check by December 31st.

2. The "Refund" Income

If you aggressively overpay the PTE tax in December to lower federal income, and the entity gets a refund in June:

• Tax Benefit Rule: That refund is Taxable Income in the year received.

• Don't forget to book the refund as income (or a reduction of the deduction) in the following year, or you will underreport income.

3. State Credit Limitations

Not all states play nice with each other.

• Scenario: You have a California resident partner in a Utah partnership. The Utah partnership pays Utah PTE tax.

• The Risk: California may not allow the partner to claim a credit for the taxes paid by the Utah entity, because California requires the taxes to be paid by the individual to grant the credit (unless specific reciprocity exists). The client ends up double-taxed.

4. Basis Reduction Timing

The PTE payment reduces the partner's/shareholder's Outside Basis.

• The Trap: If a partner is already running low on basis and takes a distribution in the same year, the PTE payment might strip their basis to zero, causing the distribution to be taxable as a Capital Gain. You must model the basis before making the election.

Conclusion: It's Not "Free Money"

The PTE election is a powerful tool, likely saving your clients 30% to 40% on their state tax bill. But it transforms a simple personal expense into a complex business deduction with basis, timing, and character implications.

Before you check the box, make sure you’ve run the simulation.

Need to track the basis impact of your PTE payments?

The S Corporation Basis Engine and 704(d) Basis Tracker are designed to handle complex entity-level payments. Ensure your PTE election doesn't trigger an unexpected gain on distributions.