SALT Cap Workarounds That Actually Hold Up

Salt cap workarounds are state level elections that let a pass through business pay your state income tax at the entity level so the payment dodges the federal cap on the state and local tax deduction. Here is the problem they solve. Since 2018 the federal deduction for state and local taxes you claim on your personal return has been capped. For 2026 that combined cap sits at $40,400 under the One Big Beautiful Bill Act framework, and it phases down for very high income taxpayers back toward a $10,000 floor. The IRS describes the underlying deduction and its limits on its page covering deductible state and local taxes, and you claim the deduction itself on Schedule A of Form 1040. If you live in a high tax state like New York or California and you earn well into six or seven figures, the tax you actually pay your state dwarfs that capped number.

Run the math and the pain shows up fast. Say you are a New York City partner with $900,000 of pass through income. Your combined New York State and City income tax can land north of $80,000. Before the cap you deducted every dollar of that on your federal return. After the cap, on a personal return you are stuck deducting a fraction of it. That gap is real money sent to the federal government that used to stay in your pocket. The pass through entity tax fixes the timing and the character of the payment. Instead of you paying that $80,000 personally and losing most of the federal deduction, your S corporation or partnership pays it as a business expense, and the business deduction is not subject to the personal cap at all. The cap never touches a deduction taken on the business return.

The mechanics rest on IRS Notice 2020-75, which blessed this approach. The Treasury confirmed that state taxes paid by a partnership or an S corporation are deductible by the entity in computing its non separately stated income, and that the deduction is not subject to the individual cap. That single notice is why forty plus states built these elective regimes. The entity files its return, pays the state tax, deducts it against business income, and passes a smaller net figure through to you. You then usually get a credit on your own state return for the tax the entity already paid, so you are not taxed twice at the state level. The credit on your personal return is what keeps the state from collecting the same tax from both the entity and from you.

A worked example makes it concrete. Take that $900,000 of income flowing through a partnership. The partnership elects in, pays roughly $80,000 of New York pass through entity tax, and deducts it. Your federal taxable income from the partnership drops by about $80,000. At a 37 percent federal marginal rate that deduction is worth close to $29,600 in federal tax you no longer owe. You then claim a New York credit for your share of the entity tax, so your personal New York bill is reduced accordingly. The federal savings is the prize. Compare that against the alternative, where the same $80,000 paid personally generates almost no usable federal deduction once the cap and the phasedown bite. The difference between those two outcomes is the entire reason these elections exist.

We see this every year. A new client comes in convinced they cannot do anything about the cap because their old accountant never raised it. They had two or three years where the election was available and nobody filed it. Those years are usually gone. The election is annual and the deadline is firm, so a missed year is a permanently missed deduction. Edge case worth flagging. If most of your income is W-2 wages rather than pass through profit, these salt cap workarounds do nothing for you because there is no entity to make the election. They only help income that runs through a partnership or S corporation. A second edge case shows up with trusts that own partnership interests, where the credit can flow oddly to beneficiaries. If you want us to look at whether your structure qualifies, start at our new client inquiry page and we will map it out.

The pass through entity tax works by moving the state income tax bill off your personal return and onto the business return, where the federal cap does not reach. That is the whole trick, and it is the engine behind every one of the salt cap workarounds in the country. Walk through the flow. Normally a partnership or S corporation does not pay income tax itself. It passes income through to owners, who report it and pay state tax personally. Under a pass through entity tax regime, the state lets the entity volunteer to pay that state tax at the entity level instead. The entity deducts the payment as an ordinary business expense, which shrinks the income that flows to you, and you pick up a credit on your state return for the tax already paid on your behalf.

IRS Notice 2020-75 is the legal foundation. In November 2020 Treasury issued that notice confirming that an entity level tax on a partnership or S corporation is deductible at the entity level and is not one of the individual itemized state and local taxes subject to the cap. The IRS keeps the relevant entity returns documented on its pages for Form 1120-S for S corporations and Form 1065 for partnerships. The entity tax payment reduces the ordinary business income reported on those forms and on each owner Schedule K-1. That reduction is permanent and it is federal, which is what separates this from a simple timing shuffle.

Here is the sequence in practice. First, the entity makes the election for the tax year, which most states require by a specific date. Second, the entity calculates its pass through entity tax, generally a flat or graduated rate applied to the owners distributive share of income sourced to that state. Third, the entity pays the tax, often through estimated payments during the year. Fourth, the entity deducts the payment, lowering the federal income reported on the K-1. Fifth, each owner claims a credit on their personal state return for their share of the tax the entity paid. The federal deduction at the entity level is the savings. The state credit prevents double taxation. Skip any one of those five steps and the strategy either fails or leaves money on the table.

Numbers help. Picture a California S corporation with $600,000 of income owned by two equal shareholders. The corporation elects in and pays California pass through entity tax at 9.3 percent on qualified net income, roughly $55,800. It deducts that $55,800, so the income flowing to the two owners drops by that amount. Each owner then claims a California credit for their half of the entity tax. The federal benefit, at a 37 percent bracket, is about $20,600 across the two owners. Without the election that $55,800 of state tax would have been crammed under the personal cap and largely wasted. The cash actually paid to California is the same in both worlds. The only thing that changes is whether the federal government lets you deduct it, and the election is what makes it deductible.

We see this every year. Owners assume the credit they get back on the state return means the strategy is a wash. It is not. The state credit just keeps you from paying the state twice. The federal deduction is the part that puts money back in your pocket, and that is the piece a lot of people miss when they eyeball their state refund and conclude nothing happened. Watch the cash flow too. The entity has to actually pay the tax inside the tax year for the deduction to land that year, because state tax is generally deductible in the year paid, not the year accrued, for most of these entities. One edge case. Guaranteed payments to a partner can be treated differently from distributive share income under some state regimes, so the base the tax applies to is not always your whole K-1. A related wrinkle is that resident and nonresident owners can be taxed on different slices of the entity income. If you want the entity level math run for your specific business, our tax strategy consulting team does exactly this kind of modeling.

New York and California run similar pass through entity taxes but with different rates, deadlines, and quirks, and the details decide whether the election pays off. Start with New York. The New York Pass Through Entity Tax, often shortened to PTET, lets an eligible partnership or S corporation elect in and pay tax on the income allocated to its New York resident and nonresident owners. The rate is graduated, climbing into the low double digits on higher income, and there is a separate New York City pass through entity tax layered on top for entities with city resident owners. Owners then claim a New York credit against their personal state tax for the PTET the entity paid. That two layer structure, state plus city, is what makes the New York benefit so large for Manhattan based partners.

The New York timing is the part that trips people. The annual election is generally due by March 15 of the tax year, meaning you elect for 2026 during 2026, well before you know your final numbers. Miss that March 15 window and the election is gone for the whole year. The entity also has to make estimated PTET payments during the year and file an annual PTET return. The underlying income still gets reported on the federal partnership or S corporation return documented by the IRS on its Form 1065 page, with the state tax deducted before income flows to each owner. Because the election commits you before the year plays out, the estimated payments are a judgment call that a good preparer revisits each quarter.

California works on the same principle with its own structure. The California pass through entity elective tax applies at a flat 9.3 percent on qualified net income of consenting owners. California has a notable wrinkle. To keep the election valid the entity generally must make a prepayment by June 15 of the tax year, and that prepayment has to be the greater of $1,000 or half of the prior year elective tax. Blow the June 15 prepayment and the entity loses the ability to elect for that year. The remaining balance is then due with the entity return. Owners claim a California credit for the tax the entity paid, and any excess credit can often carry forward for several years rather than vanishing.

Compare them with a number. A consultant operating through an S corporation with $500,000 of income and owners in both states would, in California, see roughly $46,500 of elective tax at 9.3 percent. In New York the same income at the graduated PTET rates produces a different figure, often higher once the city layer applies to a city resident. In both cases the entity deducts the payment under the authority of IRS Notice 2020-75, shrinking the federal income on the owner Form 1120-S Schedule K-1. The federal deduction is the win in either state. The state where you actually pay more tax is the state where the election returns more federal benefit, which is why we run both before deciding how aggressively to fund each.

We see this every year. A client with entities in both New York and California assumes one election covers everything. It does not. Each state has its own election, its own form, its own deadline, and its own credit mechanics, so a multistate owner is filing separate elections and tracking two calendars. The June 15 California prepayment and the March 15 New York election fall on different dates, and missing either costs you that state for the year. Edge case. A nonresident owner of a New York entity may still benefit from the New York PTET credit, but the interaction with their home state credit for taxes paid can get messy and occasionally reduces the net benefit. Another edge case is an entity that does business in both states, where income sourcing rules decide how much of the profit each state can tax. If your ownership spans both coasts, our tax compliance group keeps the dual calendars and files both elections so neither slips.

The owners who benefit most are high income people whose money flows through a partnership or S corporation in a high tax state, and the people who should skip these elections are wage earners and those in low or no tax states. Let me draw the line clearly. The pass through entity tax only helps income that runs through an electing entity. If you are a partner in a law firm, a shareholder in a profitable S corporation, or a member of an operating LLC taxed as a partnership, and that business throws off real income in New York, California, New Jersey, or another high tax state, you are the target taxpayer. The bigger your state tax bill relative to the $40,400 federal cap, the larger your benefit. That ratio, your real state tax over your usable cap, is the single best predictor of whether electing is worth it.

Income level matters because the federal cap phases down for very high earners under the One Big Beautiful Bill Act framework, drifting back toward the $10,000 floor as income climbs. The IRS lays out the deductible taxes and their limits on its Topic 503 page, and you should confirm the current year figures there because these numbers move. The further your real state tax exceeds whatever personal cap applies to you, the more the entity level deduction recaptures. For a partner paying $120,000 of state tax with a personal cap near the floor, the entity election can move well over a hundred thousand dollars of deduction back onto a deductible footing, which at a top federal rate is tens of thousands of real dollars.

Now the people who should skip it. If almost all of your income is W-2 wages, there is no pass through entity to make the election, so the workaround is unavailable. If you live in a state with no income tax, there is nothing to elect because there is no state income tax to shift. If your state income tax already sits comfortably under the federal cap that applies to you, the election adds filing complexity for little or no gain. And in a handful of situations the entity tax rate is higher than the owners own marginal state rate would have been, which can erode the benefit, so the math has to be run rather than assumed. A thin margin business with low net income often falls into this skip it group.

A worked example shows the dividing line. Two clients, both in New York. Client A is a salaried executive earning $700,000 of W-2 wages with no business. The election does nothing for Client A because there is no entity. Client B earns $700,000 through a partnership. Client B elects in, the partnership pays roughly $70,000 of New York PTET and deducts it on the partnership return, and at a 37 percent federal rate Client B saves close to $25,900 federally. Same income, same state, wildly different outcome based purely on whether the income is wages or pass through profit. That contrast is the cleanest way to see who the election is built for.

We see this every year. A W-2 client reads about the pass through entity tax, gets excited, and asks why we have not elected it for them. The honest answer is that there is nothing to elect, and structuring a real business purely to chase the deduction rarely survives scrutiny. Edge case. An owner who is also an employee of their own S corporation has both wage income and pass through income, so only the pass through slice qualifies for the election while the W-2 portion stays capped. A second edge case involves owners with passive losses, where the entity tax can interact with loss limitations in ways that delay the benefit. If you are not sure which bucket your income falls into, our tax strategy consulting team will sort the wage income from the pass through income and tell you straight whether electing is worth the filing burden.

You elect a pass through entity tax by having the entity file the state election by its deadline, make the required payments, and then deduct the tax on the federal return, and the mistakes that blow it up are almost always missed deadlines and missed payments. Here is the process step by step. The entity, not you personally, makes the election. Most states require the election through the state tax portal by a fixed date, often early in the tax year. New York generally requires the election by March 15 of the tax year. California requires a prepayment by June 15 to keep the election alive. The entity then calculates its tax, pays it, files the annual entity tax return, and reports the reduced income on each owner Schedule K-1.

On the federal side nothing new gets filed for the election itself. The entity simply deducts the state tax it paid as a business expense on its Form 1120-S or Form 1065, and that deduction is what survives the cap under IRS Notice 2020-75. The state income still ultimately ties back to the owners, and the owners claim the matching state credit. The IRS background on these entities and their filing duties lives on its S corporations page, which is worth a read if your entity is newly converted and you are still learning its filing rhythm.

A concrete walkthrough. A New York partnership with $800,000 of income wants in for 2026. By March 15, 2026 it files the PTET election through the state portal. During 2026 it makes estimated PTET payments so the tax is actually paid inside the year, roughly $75,000 at the graduated rates. The partnership deducts that $75,000 on its Form 1065, dropping each partner allocated income. The partnership files its annual PTET return in 2027, and each partner claims a New York PTET credit on their 2026 personal return. At a 37 percent federal rate the $75,000 deduction is worth about $27,750 in federal tax saved. Every dollar of that depends on the March 15 election having been filed on time and the cash having gone out the door before year end.

Now the mistakes. The biggest one is the missed election deadline. These deadlines are firm and there is usually no relief, so an election filed even one day late is dead for the entire year. The second is failing to pay the tax inside the tax year. Because state tax is generally deductible when paid, an entity that elects but defers payment into the following year can lose the deduction for the year it wanted it. The third is forgetting the owner side credit, which leaves owners paying the state twice. The fourth, in California, is missing the June 15 prepayment, which invalidates the whole election. Each of these is avoidable with a calendar and a checklist, yet each one walks through our door every spring.

We see this every year. A client converts to an S corporation in February, nobody calendars the state election deadline, and the first pass through entity tax election quietly lapses. By the time the return is prepared the following spring the window closed months earlier and the deduction is gone. Edge case. If owners join or leave the entity mid year, the allocation of the entity tax and the matching credits has to track each owner period of ownership, and getting that allocation wrong can leave a departing owner with a credit they cannot use. Another edge case is an entity with an owner in a state that does not grant a credit for taxes paid to other states, which can quietly undercut the benefit. The fix is to treat the election like a hard deadline on the corporate calendar, not a tax season afterthought. If you want the elections filed and the payments calendared so nothing lapses, our corporate returns team handles the filings and the deadlines, and you can reach us through our new client inquiry page.