Pass-Through Entity Tax on a Business Sale: Turning State Tax Into a Federal Deduction

How the election works

A PTET is a state income tax that an S corporation or partnership chooses to pay on its owners' shares of income. The owners then claim a credit for that tax on their own state returns, so the state collects roughly the same amount. The federal difference comes from IRS Notice 2020-75: a state income tax paid by the entity is deducted in computing its non-separately stated income, it flows to owners as a smaller ordinary K-1 number, and it is not counted against any owner's SALT deduction limit. States began enacting these elections after the $10,000 cap arrived in 2018.

Why the sale year makes it worth so much

P.L. 119-21 raised the SALT cap to $40,000 for 2025 and $40,400 for 2026, rising 1% a year through 2029 and returning to $10,000 in 2030. But the cap is cut by 30% of modified AGI above $500,000 (2025) or $505,000 (2026), never below $10,000 (IRC 164(b)(7)). For a joint return in 2026 that floor arrives at $606,333 of MAGI. A seven-figure sale pushes almost every seller far past that point, so without an election the state tax on the gain is almost entirely nondeductible. Section 70120 of the law changed only the individual limit and left entity-level elections alone.

California, for example, taxes the sale gain as ordinary income at rates up to 13.3% including the 1% surcharge on income over $1 million (FTB rate schedules, 2025). That state tax, paid through the entity, becomes a federal deduction worth up to the 37% bracket (Rev. Proc. 2025-32, 2026).

Which sales the PTET reaches, and which it misses

• Asset sale by the entity: the gain is entity income, so it is in the PTET base. This is the main case.
• Deemed asset sales: a Section 338(h)(10) or 336(e) election or an F reorganization makes the S corporation or LLC the seller for tax, so the gain generally lands in the entity's PTET base too. Confirm with your state; see asset sale vs stock sale.
• Direct sale of S corporation stock or partnership interests: the gain belongs to the owner, not the entity, so in most states the PTET cannot reach it.
• Sole proprietors, single-member LLCs and C corporations: not eligible. New York, for example, excludes single-member LLCs unless taxed as S corporations. A C corporation already deducts its own state tax; its problem is double taxation.

The asset-by-asset character rules are on capital gains tax on the sale of a business.

The federal value in numbers

Our first run is a California S corporation asset sale with no election: the owners pay $802,251 in federal tax caused by the sale, and their SALT deduction is stuck at the floor. In the second run the entity pays $334,800 of PTE tax (9.3% of the sale income, FTB, 2026) during 2026. That deduction comes off the ordinary K-1 income, starting with the $600,000 of equipment recapture taxed at up to 37% (2026), and federal tax caused by the sale falls to $706,331, a saving of $95,920. Part of the benefit comes back as alternative minimum tax ($25,778 in this run), which is why the saving is less than 37% of the deduction.

The deduction is ordinary even when the gain is capital, so a PTET on a sale that is mostly goodwill still offsets ordinary K-1 income first, and any excess becomes an ordinary loss. Owners who are passive in the business may also see a smaller net investment income tax base.

Timing: pay in the sale year

Notice 2020-75 allows the deduction in the taxable year the entity pays the tax. If the S corporation sells in June 2026 but pays the PTET with its return in March 2027, the deduction lands in 2027, possibly a year with little income and a lower rate, and possibly a year the entity has already wound down. Making estimated PTET payments before December 31 of the sale year puts the deduction where the income is. See year-end timing.

Seller financing adds a second wrinkle. On an installment sale the entity recognizes gain as principal arrives, so it must stay in existence and keep electing each year to cover later gain. If an S corporation liquidates and distributes the note, IRC 453B(h) shifts later gain to the shareholders, outside the entity's PTET base.

State elections and deadlines

Most states with an income tax now offer an election, each with its own base, rate and deadline; check your state's revenue department site before the sale year starts, and the state-by-state capital gains table for the underlying rate. To model the election alongside an installment note and other options, get the Big Sale Tax Analysis.

Run your own numbers

Frequently asked questions