Under IRS Notice 2020-75, an S Corporation Deducts State Income Tax That Never Touches the Owner’s SALT Cap

The One Big Beautiful Bill Act raised the federal cap on state and local tax (SALT) deductions to $40,000 for tax year 2025 and $40,400 for tax year 2026. Business owners with large incomes lose much of that increase. Once income crosses a threshold, the cap shrinks, and it can fall back to a $10,000 floor.

Owners of partnerships and S corporations still have a workaround. Under IRS Notice 2020-75, the business itself can pay and deduct state income tax through what most states call a pass-through entity tax, or PTET. That payment never counts against the owner’s personal SALT cap.

How the SALT Phasedown Shrinks the Bigger Cap

Two tax provisions set the limit. Under 26 U.S.C. § 164(b)(6), an individual’s SALT deduction can’t exceed the “applicable limitation amount,” and married people filing separately get half of it. Section 164(b)(7) sets that amount for each year. For tax years beginning before 2030, the cap shrinks by 30% of the amount by which modified adjusted gross income (MAGI) passes a threshold. Separate filers get half the threshold.

The reduction ends at the floor. The IRS Instructions for Form 1040 and Form 1040-SR state it the same way: the limit is $40,000 ($20,000 if married filing separately), reduced once MAGI passes $500,000 ($250,000 if married filing separately), and never pushed below $10,000 ($5,000 if married filing separately).

Take a example couple who own an S corporation in a high-tax state and report MAGI far above $505,000 in tax year 2026. The phasedown can put them right back at the $10,000 limit that applied under the 2017 tax law.

What IRS Notice 2020-75 Lets the Business Deduct

The notice builds on old precedent. It cites Revenue Ruling 58-25, a 1958 ruling that let a partnership deduct a Cincinnati tax on its net profits. It also points to 2017 congressional language saying entity-level taxes shown on a Schedule K-1 “will continue to reduce such partner’s or shareholder’s distributive or pro-rata share of income”.

The key term is “Specified Income Tax Payment”: any amount a partnership or S corporation pays to a State, a political subdivision of a State, or the District of Columbia to meet income tax imposed on the entity. Per the notice:

• It applies whether the tax results from an election by the entity or is required, and whether owners receive a state credit, deduction or exclusion based on their share.
• The entity deducts it in computing taxable income for the year it pays.
• It flows through inside each owner’s share of non-separately stated income or loss, meaning the single bottom-line profit figure on the Schedule K-1. That’s the form a pass-through sends each owner to report their share. The payment gets no line of its own.
• It isn’t counted when the SALT limit is applied to individual owners.
• It covers payments made on or after November 9, 2020, with an option to apply it to certain earlier payments.
• Income taxes imposed by U.S. territories are excluded.

The notice announced that Treasury and the IRS intended to issue proposed regulations. Those regulations have not been issued, and the notice says taxpayers may rely on it until they are. It remains the IRS’s guidance on PTET.

Who Gains From PTET and Who Gets Left Out

A pass-through entity is a business whose profits flow to the owners’ personal returns, so the business itself pays no federal income tax. An S corporation is a corporation that has elected that treatment. Partners and S corporation shareholders in states that offer an entity-level tax are the ones who benefit.

The notice covers partnerships and S corporations only. W-2 employees can’t use this path, and neither can retirees living on pensions, IRA withdrawals and Social Security. Their state income and property taxes stay inside the personal cap.

The stakes are highest where incomes and costs are highest. Connecticut, Massachusetts, New York, California and New Jersey rank near the top of the Bureau of Economic Analysis’s 2024 per capita income figures, and all five have cost-of-living indexes above the national average. Each state sets its own PTET rules, and owners have to follow their state’s version.

Fine Print Owners Should Check Before Electing

• Election rules and timing. Each state sets its own process and deadlines.
• Where the deduction lands. The PTET payment lowers the K-1 income that flows to the owner instead of showing up as an itemized deduction. The 1958 opinion held that partners could still claim the standard deduction. Lower K-1 income can also reduce adjusted gross income, the number many other income tests start from.
• Guidance status. The rules sit in a notice, and final regulations would carry more weight. Watch for any proposed regulations that change its terms.
• Snapback. For tax years beginning after 2029, the personal cap returns to $10,000, which may change the math for owners later.

If your business income puts you in the phasedown, go over a PTET election with a tax professional who knows your state’s rules, and do it before your state’s election window closes.

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