SALT Cap Workarounds for Some Pass-Through Entities Are Threatened by One, Big, Beautiful Bill

The One, Big, Beautiful Bill (OBBB) includes multiple tax provisions that will impact state and local taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. systems and subnational revenues. Notably for owners of pass-through businesses, the reconciliation package (1) raises the state and local tax (SALT) deduction cap, (2) denies the benefit of pass-through entity-level taxes that had previously worked around the SALT cap for such pass-through businesses, and (3) increases the Section 199A deduction for qualifying pass-through entities.

The SALT deduction, currently capped at $10,000 per household, is increased to $40,000 for married couples with income at or below $500,000 under the proposed legislation, gradually phasing down to $10,000 for higher income levels. The OBBB also extends several Tax Cuts and Jobs Act of 2017 (TCJA) changes to individual and corporate brackets, deductions, and credits, affecting state tax policy either directly (e.g., when states conform to the federal tax code) or indirectly (e.g., through behavioral responses of taxpayers), along with certain new pay-fors and restrictions.

The TCJA established a temporary 20 percent deduction for qualified business income (the QBI deduction, also known as the Section 199A deduction) for certain sole proprietorships, partnerships, S corporations, and some trusts and estates through the end of 2025. Starting in 2026, OBBB proposes to make the QBI deduction permanent and increase its size to 23 percent along with additional changes to the phase-in of previously established limitations. To qualify for the updated QBI deduction, pass-through businesses also need to demonstrate that they are “qualifying entities,” meaning that 75 percent of their gross receipts are derived from a qualified trade or business. Pass-through entities classified as specified service trades or businesses (SSTB) are restricted in their ability to claim the QBI deduction once income exceeds certain thresholds ($483,900 for joint filers, as of 2024), a TCJA exclusion retained in the OBBB in modified form. These businesses include those providing services in accounting, health care, law, consulting, financial services, investment management, athletics, and the performing arts, among other specialized fields.

Qualified pass-through businesses benefit substantially from the deduction, though they—along with SSTBs ineligible for the deduction—were also subject to the TCJA’s $10,000 SALT cap. But with the introduction of the cap, many states adopted workarounds allowing SSTBs and other pass-through entities to bypass the cap—typically by paying state-level pass-through entity taxes (PTET), which are deductible at the federal level (per IRS Notice 2020-75). According to the AICPA, 36 states now have PTETs. They vary in terms of specific qualification criteria for owners of pass-through entities, PTET election rules, and allowed credits for other states’ PTETs, but the general PTET rate is usually a top marginal individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. rate in the respective state. When electing to pay state taxes at the entity level, owners can typically claim a tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income rather than the taxpayer’s tax bill directly. —often refundable—on their individual state returns. There are other potential business benefits of PTETs beyond avoiding the SALT deduction cap, including a greater net benefit than an itemized tax deductionA tax deduction allows taxpayers to subtract certain deductible expenses and other items to reduce how much of their income is taxed, which reduces how much tax they owe. For individuals, some deductions are available to all taxpayers, while others are reserved only for taxpayers who itemize. For businesses, most business expenses are fully and immediately deductible in the year they occur, but others, particularly for capital investment and research and development (R&D), must be deducted over time. , which might be offset by the alternative minimum tax.

As originally written, the reconciliation bill appeared to deny the benefit of PTETs to all businesses, as noted by the Tax Law Center at NYU. However, a subsequent manager’s amendment reflects what was understood to be lawmakers’ intention to curtail the benefit for SSTBs (including those eligible for the QBI deduction because they remain below the income threshold), not all businesses.

Consequently, some pass-through businesses will get the dual benefit of an even higher QBI deduction of 23 percent and continued ability to take advantage of PTETs, while others are denied the benefit of the QBI deduction (a continuation of the status quo) while also losing the ability to deduct their state and local taxes above the cap—even if it’s a higher cap.

The SALT deduction cap represents good policy, and the lack of a deduction does not yield double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. . But businesses are ordinarily able to deduct their business expenses, of which taxes are a part. These PTETs, for all their shortcomings and all the questions they raised, were a patch to restore that treatment.

Disallowing SALT deduction cap workarounds for SSTBs would reduce GDP by 0.2 percent and the capital stock by 0.3 percent, per Tax Foundation analysis. And by disallowing PTETs only for some pass-through entities, the new approach diverges even more sharply from the principle of tax neutrality than the current system, by creating substantially differential tax treatment for various types of pass-through entities.

Tax code neutrality is key to future economic growth. If the choice of organizational form or industry specialization significantly affects an entity’s tax liability, unintended consequences may follow—including reduced incentives for certain businesses to continue operating and lower competition in some markets and industries.

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