The problem being solved
An individual's deduction for state and local taxes is capped. For a high earner in a state with a meaningful income tax, the cap disallows most of what is actually paid, and the disallowed portion is a real cost with no federal offset.
The states responded with a structural observation. The cap applies to individuals. A business paying state income tax deducts it as an ordinary business expense, without limit.
The mechanism follows from that. The pass-through entity elects to pay the state tax on its income at the entity level and deducts it federally. The owners then receive a credit or an exclusion on their state returns for the tax the entity paid, so the state is not paid twice.
Why the mechanism holds
Earlier state attempts to work around the cap, principally schemes converting tax payments into charitable contributions, were addressed by the Service and did not survive.
This one was treated differently. In 2020 the Service indicated that entity-level taxes of this kind are deductible by the partnership or S corporation in computing its non-separately stated income, and are not subject to the individual cap. That position is the foundation the state regimes were built on, and the number of states enacting one afterwards reflects it.
Where it goes wrong
The regimes are creatures of individual state legislatures, and they differ in ways that change the answer rather than merely the paperwork.
| Variable | Why it matters |
|---|---|
| Election timing | Some states require the election before the year begins or with an estimated payment during it. Missing the date generally forfeits the year entirely, with no late relief |
| Annual or binding | Some elections are made annually, others bind for multiple years. The second kind is a commitment made on one year's facts |
| Who consents | Some regimes require all owners to consent, or bind all owners once made. A co-owner in a different state, or one for whom the election is unfavourable, becomes a governance question rather than a tax one |
| The credit mechanism | A credit at the owner level, an exclusion of the income, or an addback, each produce different results and interact differently with residency |
| Resident credits across states | Where an owner is resident in one state and the entity elects in another, whether the home state gives credit for the entity-level tax is a state-specific question and is frequently no |
Two further points are worth stating because they surprise people who assume the election is free.
- 01The entity pays real cash on a real schedule. Estimated payments at the entity level change the entity's working capital and, in a business with partners who draw, its distribution policy.
- 02The benefit is not uniform among owners. An owner resident in a no-tax state, or one whose own state offers no credit, can be worse off under an election that benefits everyone else at the table.
General information only. This article describes law and practice as we understand them at the time of writing. It is not tax, legal, accounting, or investment advice, it does not consider your circumstances, and it does not create an advisor-client or attorney-client relationship. Odyssey Strategic Advisors LLC is not a law firm and is not a CPA firm. Confirm any position with your own tax professional before acting on it. See our disclosures.