Recent legislative proposals, particularly those contained within "Subtitle A—Make American Families and Workers Thrive Again" and "Subtitle C—Make America WIN Again", signal profound changes to the deduction for state and local taxes (SALT), with a significant impact on partnerships and S corporations and their owners. As tax advisors, understanding these modifications is crucial for effective planning and compliance for taxable years beginning after December 31, 2025.

This proposed legislation was approved on a party line vote by the House Ways & Means Committee on May 14, 2025.

Background: The Passthrough Entity SALT Planning Environment

Prior to these proposed changes, for taxable years beginning after December 31, 2017, and before January 1, 2026, Public Law 115-97 imposed a temporary limitation on individual itemized deductions for state and local taxes, capping the aggregate deduction at $10,000 ($5,000 in the case of a married individual filing a separate return). This limitation applied to state and local income, war profits, excess profits, and sales taxes, as well as state and local and foreign property taxes not paid or accrued in carrying on a trade or business or an activity described in section 212. Foreign real property taxes were specifically disallowed under this exception.

In response to this limitation, many states enacted passthrough entity (PTE) tax regimes, allowing partnerships and S corporations to elect to pay income-based entity-level taxes. For Federal tax purposes, IRS Notice 2020-75 announced the IRS’s intention to issue regulations providing that state and local income tax payments made by partnerships and S corporations on their income are deductible by such entities in computing their non-separately stated income or loss. This effectively allowed owners of electing PTEs to bypass the individual SALT cap by converting what would have been a limited individual deduction into a deduction against entity-level income flowing through to them.

The New Individual SALT Limitation

The proposed legislation removes the temporary limitation enacted by Public Law 115-97. In its place, a new, permanent limitation is introduced under a modified Section 275 of the Internal Revenue Code. This new limitation restricts an individual’s deduction for certain state and local and foreign taxes. Specifically, an individual is permanently denied a deduction for "disallowed foreign real property taxes," defined as foreign real property taxes other than those paid or accrued in carrying on a trade or business or a section 212 activity.

Furthermore, an individual’s deduction for the aggregate of "specified taxes" is limited to $15,000 in the case of a married individual filing a separate return, and $30,000 for any other taxpayer. The sources indicate this limitation will be subject to a phase-down based on the taxpayer’s modified adjusted gross income. Modified AGI for this purpose includes adjustments for amounts excluded under sections 911, 931, and 933.

Fundamental Shift for Partnerships and S Corporations: Separate Stating and Entity-Level Deduction Denial

The most impactful change for passthrough entities and their owners lies in how these entities must now treat specified taxes. The proposal explicitly modifies the rules governing the computation of taxable income for partnerships and S corporations.

Under the proposal, partnerships are required to separately state, and are denied an entity-level deduction for, certain taxes and payments. Specifically, Section 702(a) is amended to require a partner’s distributive share of the partnership’s following items to be separately taken into account:

Foreign income, war profits, and excess profits taxes.
Income, war profits, and excess profits taxes paid or accrued to U.S. possessions.
Specified taxes (other than income, etc. taxes paid or accrued to U.S. possessions).
Disallowed foreign real property taxes.

Conformingly, Section 703(a)(2)(B) is amended to deny the partnership a deduction for any such taxes or payments listed in the modified Section 702(a)(6) in computing its taxable income. These modifications to the partnership rules trigger corresponding changes for S corporations by reason of cross-references in Sections 1366(a)(1) and 1363(b)(2).

The Joint Committee on Taxation (JCT) explanation explicitly states that these changes abrogate IRS Notice 2020-75. This means that entity-level PTE taxes, to the extent they fall within the definition of "specified taxes," will no longer be deductible by the partnership or S corporation in arriving at non-separately stated income. Instead, they will flow through as separately stated items to the partners or shareholders. Once separately stated, these amounts become subject to the new individual SALT limitation of $15,000/$30,000 for the individual owners.

Furthermore, the proposal modifies Section 704(d), the basis limitation rule for partners. For purposes of the basis limitation, a partner’s distributive share of partnership loss generally includes their distributive share of the partnership’s specified taxes to the extent the partner would otherwise be able to deduct such distributive share (taking into account the new individual SALT limitation).

State and Local Tax Allocation Mismatch Addition to Tax

The proposal also introduces a new addition to tax under Section 6659 for "State and local tax allocation mismatches". This targets situations where a partnership pays a specified tax (like a PTE tax), a partner is entitled to a state tax benefit (e.g., a credit), but the related Federal tax deduction for the partnership tax payment is disproportionately allocated to an owner not subject to the Federal SALT limit.

What Constitutes a State and Local Tax Allocation Mismatch?

A "State and local tax allocation mismatch" occurs with respect to any payment of a specified tax by a partnership. Such a mismatch exists whenever three conditions are met:

A partnership in which the taxpayer is a direct or indirect partner pays or accrues a specified tax.
The taxpayer (defined as a "covered individual," which includes an individual, estate, or trust who is directly or indirectly entitled to specified tax benefits and takes into account any item of partnership income, gain, deduction, loss, or credit) is entitled (directly or indirectly) to one or more specified tax benefits with respect to that partnership payment.
These specified tax benefits exceed the taxpayer’s distributive share of the partnership specified tax payment amount.

For clarity, a specified tax benefit is defined as any benefit related to the partnership specified tax payment that is allowed against, or determined by reference to, a specified tax (other than a substitute payment) owed by the taxpayer. A partnership specified tax payment is any amount paid or accrued by a partnership (or certain entities treated as partnerships) for a specified tax imposed on the partnership. Specified taxes generally refer to those described in Section 275(b)(3)(A).

How the Section 6659 Tax Works

If a State and local tax allocation mismatch exists for a covered individual, Section 6659 imposes an addition to the individual's Federal income tax liability under Section 1 for the taxable year.

The amount of this addition to tax is calculated as the product of:

The highest rate of tax in effect under Section 1 for the taxable year, multiplied by
The sum of the taxpayer’s aggregate State and local tax allocation mismatches for that taxable year.

Valuing the Specified Tax Benefits

For the purpose of calculating the "aggregate dollar value" of the specified tax benefits (used in determining the mismatch amount), the value is generally deemed to be the increase in the taxpayer's specified tax liability (or reduction in credit or refund) that would occur if the benefit were not considered. This includes any carryforward of the benefit.

Alternatively, the taxpayer has the option to elect a simplified approach. Under this election:

The value of a credit or refund is simply its amount.
The value of a deduction or exclusion is 15 percent of the amount of such deduction or exclusion.

Illustrative Example

The sources provide an example to demonstrate the application:

Partnership P, located in State S, has two partners: individual I and corporation C.
P pays an entity-level income tax to State S.
Individual I receives a credit against his personal State S income tax liability due to P's payment.
For Federal tax purposes, P allocates the entire deduction for the entity-level tax payment to Corporation C.
Individual I’s State and local taxes already exceed his Federal deduction limitation under the new Section 275(b).

In this scenario, unless the allocation to C is adjusted under existing rules (e.g., for lack of substantial economic effect), the new addition to tax under Section 6659 will increase Individual I’s Federal income tax liability. This increase is intended to bring I’s tax liability to approximately what it would have been if P had allocated the entity-level tax payment to I in proportion to I’s State S tax credit (relative to C’s State S tax credit, if any).

Related Partnership and S Corporation Rules

To facilitate these changes, corresponding modifications are made to the rules governing partnerships and partners, as well as S corporations and their shareholders. Notably, Section 702(a)(6) is amended to require specified taxes to be taken into account separately by partners. Section 703(a)(2)(B) is also amended to disallow partnership deductions for taxes or payments described in Section 702(a)(6).

The Secretary of the Treasury is granted authority to issue regulations or other guidance necessary to implement these provisions, including rules to prevent avoidance through partnership allocations or other arrangements. Regulatory authority is also provided under Section 275(b) for similar anti-avoidance purposes, addressing issues like substitute payments and the allocation of specified taxes between business and non-business activities.

Decoding "Specified Taxes"

Understanding what constitutes a "specified tax" is paramount, as this determines which taxes paid by a passthrough entity are subject to the new separate stating rule, denied entity-level deduction, flow through to owners, and become subject to the $15,000/$30,000 individual cap.

Under the proposal, "specified taxes" are defined as comprising:

State and local and foreign property taxes, other than:
- Disallowed foreign real property taxes, and
- State and local property taxes paid or accrued in a trade or business or an activity described in section 212.
State and local income, war profits, excess profits, and general sales taxes, subject to a critical exception.

The 75% Gross Receipts Test: A Narrow Exception

The critical exception within the definition of specified taxes applies only to the income, war profits, excess profits, and general sales tax component when paid or accrued by a partnership or S corporation.

These income, etc. taxes paid by a partnership or S corporation in carrying on a qualified trade or business (within the meaning of Section 199A(d)(1)) are not considered "specified taxes" if at least 75 percent of the gross receipts (within the meaning of Section 448(c)) of all trades or businesses under common control (determined under Section 52(b)) with such partnership or S corporation are derived from a qualified trade or business.

Note that specified service trades or businesses (SSTBs) are not considered a qualified trade or business under Section 199A(d)(1)). Thus, SSTBs will not receive any benefit from a state level passthrough entity tax under the proposed law.

Implication of the 75% Test:

If a partnership or S corporation pays state/local income, etc. taxes on income from a qualified trade or business, and the entity (including all trades/businesses under common control) meets the 75% gross receipts test, these specific income-based taxes are not "specified taxes."
However, even if they are not "specified taxes," they are still subject to the new rule requiring separate stating and denying the entity-level deduction. They flow through to the owners.
Crucially, because they are not "specified taxes" due to meeting the 75% test, they are not subject to the $15,000/$30,000 individual SALT limitation that applies only to "specified taxes".
Conversely, if a partnership or S corporation pays state/local income, etc. taxes on income from a trade or business that is not a qualified trade or business (e.g., a specified service trade or business if the owner’s income exceeds the threshold amount, although the QBI phase-out rules are also being modified), or if the entity (including all trades/businesses under common control) fails the 75% gross receipts test, those income-based taxes are "specified taxes." They are separately stated and are subject to the $15,000/$30,000 individual SALT limitation at the owner level.
Note that State and local and foreign property taxes paid by a partnership or S corporation are included in the definition of "specified taxes", and this inclusion is not subject to the 75% gross receipts test. Therefore, these property taxes paid by a passthrough entity will be separately stated and subject to the $15,000/$30,000 individual SALT limitation.

Effective Date and New Reporting Burdens

The amendments removing the temporary SALT cap, introducing the new $15,000/$30,000 limitation on specified taxes, defining specified taxes, requiring separate stating, denying entity-level deduction for specified taxes, and modifying basis rules and allocation mismatch rules, are all applicable to taxable years beginning after December 31, 2025.

Additionally, partnerships and S corporations will have a new reporting obligation. They are required to report, on their returns (Form 1065 and Form 1120-S) and on Schedule K-1 furnished to owners, whether or not the entity had any gross receipts (within the meaning of Section 448(c)) from a specified service trade or business (within the meaning of Section 199A(d)(2)) during the taxable year. This reporting requirement for SSTB gross receipts also takes effect for taxable years beginning after December 31, 2025.

Conclusion: Navigating the New Landscape

These proposed changes represent a significant shift from the current PTE workaround for the SALT limitation. Effective for 2026 and beyond, passthrough entities paying income, war profits, excess profits, or general sales taxes, or property taxes will generally be required to separately state these items. Individual owners will face a new permanent $15,000/$30,000 limitation on their deduction for most of these taxes, unless the entity-level income taxes qualify for the narrow 75% gross receipts test exception. The denial of the entity-level deduction for specified taxes and the separate stating requirement abrogate the planning opportunities facilitated by Notice 2020-75.

Tax professionals must analyze the nature of the taxes paid by passthrough entities (property vs. income/sales), whether the entity is engaged in a qualified trade or business, and whether the 75% gross receipts test is met to determine if the individual owner’s deduction for those taxes will be subject to the new $15,000/$30,000 cap. Furthermore, the new reporting requirements and the potential addition to tax for allocation mismatches necessitate careful consideration.

The period leading up to the 2026 effective date provides a window for reviewing entity structures, income streams, and state tax payment methods to prepare for this new SALT environment.

Prepared with the assistance of NotebookLM.