IRS Notice 2020-75 Solidifies Entity-Level Tax Deduction for S Corporations and Partnerships, Bypassing Individual SALT Cap

On November 9, 2020, the Internal Revenue Service (IRS) issued Notice 2020-75, providing crucial clarity for S corporations and partnerships by affirming that state and local income taxes paid at the entity level can be deducted by the business itself. This directive effectively allows owners of these pass-through entities (PTEs) to bypass the federal $10,000 State and Local Tax (SALT) deduction limitation, a cap that has significantly impacted high-income taxpayers since its inception.

The Notice, formally announced on that date, informed taxpayers that forthcoming proposed regulations would clarify this treatment. It specifically stated that state and local income taxes imposed on and paid by a partnership or S corporation on its income are allowed as a deduction by the PTE in computing its non-separately stated taxable income or loss for the year of payment. This means such payments are not taken into account when applying the SALT cap limitation to any individual who is a partner or shareholder in the PTE. This guidance has provided much-needed certainty for business owners and their advisors in navigating the complexities of the federal tax code.

The federal SALT deduction limitation, set at $10,000 per taxpayer, was a key provision of the Tax Cuts and Jobs Act (TCJA) of 2017. This cap significantly altered the tax landscape for individuals, particularly those in high-tax states, by limiting their ability to deduct state and local property, income, or sales taxes on their federal returns. In response to this limitation, many states began enacting their own pass-through entity (PTE) tax regimes, often referred to as “SALT workarounds.” These state-level provisions allowed partnerships and S corporations to elect to pay income-based taxes at the entity level, rather than having individual owners pay these taxes directly.

IRS Notice 2020-75 effectively “blessed” these state workaround arrangements, confirming that the entity-level payments would be deductible for federal income tax purposes. The payments are deducted by the entity when computing its taxable income for the year they are paid. This deduction then flows through to the individual owners inside their share of non-separately stated income or loss, appearing as part of the single bottom-line profit figure on their Schedule K-1. Crucially, these entity-level payments are not counted when the personal $10,000 SALT limit is applied to individual owners, thereby preserving a significant deduction that would otherwise be capped.

The scope of Notice 2020-75 covers payments made on or after November 9, 2020, with an option to apply it to certain earlier payments. It applies whether the state tax results from an election by the entity or is required, and irrespective of whether owners receive a state credit, deduction, or exclusion based on their share. However, it explicitly excludes income taxes imposed by U.S. territories. The IRS’s reasoning for this interpretation is rooted in a prior revenue ruling, Rev. Rul. 58-25, which allowed a city tax paid by a partnership on its net profits to be deductible in computing the partnership’s taxable income, with the deduction flowing through to partners.

For small and mid-sized businesses structured as S corporations or partnerships, this guidance has been a significant boon. Owners with substantial incomes, particularly those operating in states with high income tax rates, faced steep increases in their federal tax liability due to the original $10,000 SALT cap. The ability to deduct state income taxes at the entity level provides a critical mechanism to mitigate this impact. While the “One Big Beautiful Bill Act” later raised the federal cap on individual SALT deductions to $40,000 for tax year 2025 and $40,400 for tax year 2026, this increase is subject to a phasedown for high-income earners. Once income crosses a certain threshold (e.g., $500,000 in Modified Adjusted Gross Income), the cap shrinks, potentially falling back to the original $10,000 floor. Therefore, the entity-level deduction remains a vital strategy for many business owners, ensuring that their state income tax payments are fully deductible regardless of their personal income levels.

Since the initial state enactment of SALT parity legislation, more than 35 states have followed suit, adopting pass-through entity tax regimes. This widespread adoption, coupled with the IRS’s affirmation in Notice 2020-75, has provided a stable framework for businesses. It is important to note that this strategy is specifically available to partners and S corporation shareholders in states offering entity-level taxes; W-2 employees and retirees cannot utilize the PTET workaround.

In our experience, the clarity provided by IRS Notice 2020-75 has been a game-changer for many of our clients, particularly those grappling with substantial state tax burdens. While the concept of an entity-level deduction seems straightforward, navigating the specific requirements of each state’s PTE tax regime, coupled with federal compliance, can be complex. We've seen firsthand how crucial it is for business owners to understand if their state offers this workaround and how to properly elect and account for it to maximize their tax efficiency. This isn't just about saving money; it's about optimizing cash flow and ensuring compliance within a dynamic tax environment. Our team at C&S Finance Group LLC specializes in tax preparation and compliance for small and mid-sized businesses, and we regularly assist clients in evaluating and implementing these strategies. Business owners seeking to understand how these rules apply to their specific situation should contact C&S Finance Group LLC at csfinancegroup.com to explore their options.

Looking ahead, while Congress has considered and rejected several efforts to repeal or limit the deduction for pass-through businesses since 2017, the landscape of tax legislation is always subject to change. Business owners and their advisors will need to remain vigilant regarding potential future legislative proposals that could impact the long-term viability or structure of these critical SALT workarounds.