Senate Eases SALT Cap Impact for Pass-Through Businesses: What You Need to Know 9

A recent move by the Senate is set to provide significant relief for pass-through businesses navigating the State and Local Tax (SALT) deduction cap. While the House’s initial “One, Big, Beautiful Bill” threatened to eliminate this crucial tax workaround for many service-based businesses, the Senate’s version restores the benefit, albeit with new limitations. This is a vital development for countless small and medium-sized enterprises (SMEs) across the United States.

Understanding Pass-Through Entity Taxes (PTETs) and the SALT Cap

Currently, 36 states utilize Pass-Through Entity Taxes (PTETs) as a strategic workaround to the $10,000 SALT deduction cap. This allows pass-through businesses (such as partnerships, S corporations, and LLCs) to pay taxes at the entity level, which then provides a credit against the owners’ individual income tax liability. Essentially, it helps these businesses avoid the full impact of the SALT cap on their income.

The House’s original proposal would have increased the cap to $40,000 but phased it back to $10,000 for high earners. Crucially, it would have stripped the PTET benefit from “specified service trades or businesses” (SSTBs), including legal, accounting, medical, consulting, and financial firms. This would have left many professionals fully exposed to the SALT cap.

Senate’s Approach: Restoring Benefits, Adding Nuances

The Senate’s refined language maintains the existing $10,000 SALT cap but takes a more balanced approach to PTETs. Here’s how income taxed at the entity level will be deductible for each owner under the Senate plan:

• Remaining SALT Cap Utilization: Any portion of the $10,000 SALT cap not used by an owner for personal deductions (other income and property taxes) can be applied to PTETs.
• Beyond the Cap: Above that, owners can deduct the greater of $40,000 or 50% of their PTETs.

This change offers a lifeline to SSTBs, ensuring they can continue to leverage PTETs for tax relief.

Cracking Down on PTETs as Revenue Generators

The Senate bill also addresses concerns about some states using PTETs as a primary revenue source by imposing higher-than-usual entity-level tax rates. Some businesses currently elect to pay these higher state rates because the resulting federal tax savings outweigh the increased state burden.

To prevent this, after an 18-month transition period, the Senate will render an entity-level tax ineligible for the deduction if it yields more than 102% of what an individual with the same taxable income would ordinarily owe. The bill also disallows “substitute payments” designed to sidestep these new PTET restrictions.

Preventing “SALT Allocation Mismatches”

Both the House and Senate bills include an anti-abuse penalty for SALT allocation mismatches. This measure aims to prevent partnerships from disproportionately allocating PTET benefits to partners in high-tax states or to C corporations, ensuring that the benefits are distributed in line with a partner’s distributive share of the tax payment.

What About Other Business Taxes?

It’s important to remember that non-income taxes on pass-through businesses, such as payroll taxes, real and personal property taxes, capital stock taxes, and gross receipts taxes, are already deductible as ordinary business expenses. These have never been subject to the SALT cap and are distinct from the PTET workarounds. The new restrictions only apply if such a tax is offered as a “substitute” payment to circumvent the PTET limitations.

The Future of PTETs: Continued Viability and State Adoption

Despite the Senate’s modifications, PTETs are expected to remain a substantially beneficial tax strategy. This increased certainty about their long-term viability may even encourage the few remaining states without an entity-level tax option to adopt one. Currently, Delaware, Maine, North Dakota, Pennsylvania, and Vermont are the only states with broad-based income taxes that have yet to offer a PTET.

States that currently impose higher entity-level tax rates (like Massachusetts, Wisconsin, New Jersey, California, Hawaii, Connecticut, Kansas, and Minnesota) will need to realign their rates by the end of the transition period to ensure their PTET workarounds remain deductible under the new federal guidelines.

A Broader Look at Business SALT Deductions

The debate around business SALT deductions is ongoing. While there’s a strong case for Corporate SALT (C-SALT) deductions (as these taxes are imposed directly on the corporation and don’t offset personal income), the deductibility of individual taxes through the SALT deduction often benefits high earners in high-tax states.

Ultimately, while states are concerned about the impact of high taxes on small businesses, the rates are largely within their control. PTETs have primarily served as a mechanism to shield pass-through business owners’ compensation from the full weight of state income taxes. Any limitations on these deductions should ideally be balanced with new pro-growth provisions to mitigate economic costs.

Are you a pass-through business owner, and how might these changes impact your tax planning for the coming years?