Pass-Through Entity Taxes in 2025: Federal and State Trends, Planning Traps, and Practical Insights

The landscape for state and local taxation of pass-through entities (PTEs) has undergone a seismic shift in recent years, thanks in large part to the workarounds developed in response to the federal cap on state and local tax (SALT) deductions. As we move further into 2025, the strategic decisions surrounding pass-through entity taxes (PTETs)—from elections to entity agreements—are more important than ever.

With the expiration of key provisions of the Tax Cuts and Jobs Act (TCJA) looming, and states diverging widely in how they implement their PTET regimes, tax professionals are navigating a complex and shifting terrain. Below is a comprehensive look at where things stand and what taxpayers and advisors need to be thinking about now.

I. The SALT Deduction Cap and the Rise of PTETs

When the TCJA was signed into law in 2017, one of its most controversial provisions was the creation of the SALT deduction cap under Internal Revenue Code Section 164(b)(6). Beginning in 2018, individual taxpayers could deduct no more than $10,000 ($5,000 if married filing separately) in combined state and local taxes.

This cap hit hardest in high-tax states and was widely viewed as politically motivated. It was also a revenue-raiser—the Joint Committee on Taxation estimated it would increase federal revenues by over $1.3 trillion over a decade, helping to offset the cost of other TCJA provisions.

Importantly, while the cap applied to individuals, it did not apply to taxes paid by businesses. That created an opportunity for states to design entity-level taxes on partnerships and S corporations, allowing those businesses to deduct the state tax payments in full for federal purposes and bypass the individual SALT cap.

This workaround was formally blessed by the IRS in Notice 2020-75, which confirmed that specified income tax payments made by a PTE are deductible at the entity level, without regard to the individual SALT cap. The result: A wave of states rushed to implement their own elective PTET regimes.

II. 2025: A Year of Transition and Planning Pressure

As of early 2025, most states with a personal income tax have enacted some form of PTET. A few notable states without income taxes or with limited PTET adoption remain on the sidelines. However, nearly all existing regimes are elective, with varying rules about how and when to make the election, how credits are applied at the owner level, and what entities are eligible to participate.

Adding to the complexity is the fact that many of these laws are scheduled to sunset at the end of 2025, coinciding with the scheduled expiration of the SALT deduction cap under federal law. Congress may extend the cap, repeal it, or raise the limit—but as of now, the default is that the cap disappears on January 1, 2026. That uncertainty puts added pressure on taxpayers to assess whether PTET elections still make sense this year and to plan ahead for possible changes in 2026 and beyond.

III. Key Technical and Operational Considerations

1. Planning and Payment Mechanics

Even in states that allow PTET elections, the implementation details can create logistical headaches. Common problems include:

• Misapplied payments due to SSN/EIN mismatches.

• States requiring quarterly estimated payments or specific year-end payment procedures.

• Delays in states recognizing payments or matching them correctly to owners.

These technical hurdles can interfere with both federal deductibility and state-level credit claims. Advisers should ensure clients are following the payment mechanics to the letter, and when possible, submit payments early to allow time for corrections.

2. S Corporation-Specific Pitfalls

S corporations face unique challenges under PTET regimes due to their ownership and tax rules. For example:

• The PTET deduction may not be treated as a separately stated item, complicating the treatment at the shareholder level.

• S corporations must maintain a single class of stock, meaning all distributions must be pro rata. If a PTET election results in a disproportionate benefit to some shareholders (e.g., those receiving state-level credits while others do not), the corporation may risk violating that rule.

• There may also be unintended consequences for the accumulated adjustments account (AAA), which could affect distributions and basis.

Entities with mixed resident/non-resident ownership or tiered structures need to tread carefully to avoid adverse outcomes.

3. Wide Variation Across States

Despite IRS guidance, states are not consistent in how they implement PTET regimes. Consider the following disparities:

• Some states allow a dollar-for-dollar credit to individual owners for the tax paid by the entity. Others provide only partial relief or none at all.

• States differ in whether out-of-state PTET payments qualify for a resident credit, which can result in double taxation.

• Eligibility rules vary—some limit the election to certain types of partners or members, others to certain legal entity types.

• Filing procedures, estimated payment rules, and deadlines vary widely, and missing these formalities can result in losing the deduction altogether.

Multistate businesses must evaluate the benefit and burden of electing PTET status on a state-by-state basis and consider the cumulative impact of multiple elections.

4. Interaction with Other State Regimes

PTET elections can also trigger cascading state tax issues:

• Some states continue to require nonresident withholding or composite returns, even when the PTET election is made.

• Taxpayers may face duplicate payments if both PTET and withholding are required, or if states refuse to allow credit carryforwards.

• Nonbusiness income sourcing rules may be triggered in some cases, especially where state apportionment is involved.

Advisers must model the overall impact of PTET elections across all states where the business operates and factor in the interaction with other SALT compliance requirements.

IV. PTE Agreements: Are You Covered?

Many operating agreements, partnership agreements, and shareholder agreements were not drafted with PTET elections in mind. Now, they need to be revisited.

Questions to consider include:

• Does the agreement permit the entity to make a PTET election?

• Are voting thresholds for tax decisions consistent with state PTET laws?

• How are the PTE taxes allocated among the partners? Does it align with their economic interest?

• Are guaranteed payments or cash distributions reduced by the partner’s share of PTET liability?

• Do the agreements allow flexibility to make special allocations or adjustments to reflect PTET elections?

• Is there a mechanism to compensate or credit nonconsenting or ineligible owners?

Where PTETs are being considered, agreement terms must be reviewed—and likely revised—to ensure tax elections can be made efficiently and equitably.

V. What’s Next?

The SALT deduction cap is scheduled to sunset after December 31, 2025. If Congress does not extend it, the primary rationale for PTET elections will vanish for many taxpayers. Some states have already baked this into their legislation, setting automatic sunset provisions for PTET laws. Others may revisit their policies once the federal landscape becomes clearer.

In the meantime, PTET elections remain a valuable workaround in the right circumstances—but they are not a one-size-fits-all solution. As the rules evolve and 2025 tax planning heats up, businesses and their advisors must:

• Carefully evaluate the cost/benefit of PTET elections on a multistate basis.

• Ensure payments are timely and compliant with each state’s rules.

• Review and amend governing documents to support PTET planning.

• Stay informed on federal legislative developments that could impact the long-term viability of PTET regimes.

© 2025 Jeanette Moffa. All Rights Reserved.