The Senate’s version of the One Big Beautiful Bill Act (the “Act”) was released on June 16th, following the House’s passing of its version of the bill in late May. Among the many tax-related changes in both versions of the Act is the narrowing of the pass-through entity tax (“PTET”) workarounds, commonly used by owners of pass-through entities such as partnerships and S corporations, to mitigate the limitation on deductions for state and local taxes (“SALT”) in effect since 2017. Although there are differences between the House and Senate versions, some of which are beyond the scope of this article, we provide general background of PTET workarounds and some highlights of the proposals. Changes to the PTET could result in greater taxes to members of “specified service trade or business” (“SSTBs”), which include law and accounting firms and investment partnerships, and is a cause for concern for many taxpayers in high-tax states.
Before 2017, individual taxpayers could fully deduct their state and local income taxes on their federal tax returns. However, the Tax Cuts and Jobs Act imposed a $10,000 cap on SALT deductions to individuals. Fearing migration of high net-worth residents to states with lower or no income taxes, states with higher income tax rates crafted PTET workarounds that would mitigate the impact of the SALT cap to owners of partnerships and S corporations, the typical choices of entity for resident businesses. Eventually, more than 30 states and New York City followed suit.
Very generally, a PTET workaround circumvents the cap by allowing pass-through entities to elect to pay state and local income taxes at the entity level, which then would be deductible as a business expense of the PTET (on both the federal and state/local level), resulting in lower net income for the entity, and a lower allocation of income to its owners. Additionally, the state or locality credits the individual owners credit against their share of SALT paid by the entity. Accordingly, the PTET workaround had the effect of restoring most, if not all, of SALT deductibility. The IRS generally approved of this approach in Notice 2020-75, and did not challenge PTET workarounds thereafter.
The House version of the Act eliminates the use of PTET workarounds for partners in SSTBs, but maintains the workaround for qualified trades or businesses (“QTBs”). Although the House bill would raise the SALT cap from $10,000 to $40,000 for incomes up to $500,000 (see our Brass Tax discussion of SALT deductions [here]), higher-earning partners in SSTBs likely would be hit hard by the combination of these changes.
The Senate version of the bill generally preserves the PTET workaround for all types of businesses, whether QTB or SSTB, allowing a deduction equal to the greater of (i) $40,000 of a taxpayer’s allocation of the pass-through’s SALT obligation or (ii) 50% of their overall allocation. Since the taxpayer’s allocation is not strictly capped, this version of the bill appears more favorable to higher-earning partners in SSTBs.
If the Senate passes its version of the Act, the two versions must then be reconciled before heading to President Trump’s desk for approval. Accordingly, the exact scope and impact of the Act on PTET workarounds remains uncertain. Taxpayers should continue to monitor the bill’s progress for any changes in Congress’s approach.
