SALT Deduction Limitation Presents Tax Planning Opportunities for High-Net-Worth Investors
Investment partnerships and state pass-through entity tax workarounds create powerful planning opportunities following the OBBBA's preservation of these strategies
On July 4, 2025, the President signed the One Big Beautiful Bill Act (OBBBA) into law, delivering mixed results for taxpayers dealing with state and local tax (SALT) deduction limitations. While the legislation makes the individual SALT cap permanent, it ultimately preserved the valuable Pass-Through Entity Tax (PTET) workarounds that many states have implemented.
The path to final passage involved significant uncertainty for these workarounds. The original House version would have severely restricted PTET benefits by limiting them only to certain qualifying trade or business entities, effectively excluding most services businesses and investment entities from utilizing these workarounds. The Senate Finance Committee’s proposal eliminated the House’s distinction between services businesses and other business types but imposed an even stricter set of rules that would have mostly eliminated the benefits of the workaround for all pass-through owners. In the end, the enacted OBBBA dropped all proposed restrictions on state PTET programs. Accordingly, the existing framework remains fully operational, allowing partnerships and S corporations to continue deducting state and local income taxes at the entity level rather than having these taxes flow through to individual owners subject to the SALT cap.
For individual investors who hold securities and other investment assets through partnerships or other pass-through entities, the preservation of PTET workarounds represents a particularly significant victory. These mechanisms continue to provide substantial tax savings by allowing entity-level deduction of state taxes that would otherwise be subject to individual SALT limitations. With the individual cap now permanent, the relative value of these workarounds has actually increased. The absence of additional restrictions proposed in earlier OBBBA versions creates substantial tax planning opportunities for investors in high-tax states who hold investment assets through pass-through structures.
The Rundown
The SALT deduction cap has created significant tax challenges for residents of high-tax states who can no longer fully deduct their state and local taxes.
States have developed pass-through entity tax workarounds blessed by the IRS, allowing partnerships and S-Corporations to deduct state taxes at the entity level and bypass the individual SALT cap.
Investors who have structured their investment portfolios in investment partnerships, including family limited partnerships (FLPs), may leverage the SALT workarounds to deduct state income taxes and minimize Alternative Minimum Tax (AMT) exposure when properly effected.
Evolution of state responses and IRS guidance
After unsuccessful court challenges to the SALT cap legislation, many states implemented elective pass-through entity (PTE) taxes, allowing partnerships and S corporations (”pass-through entities”) to elect entity-level taxation for state purposes. The IRS validated these approaches in Notice 2020-75, confirming that state and local income taxes imposed on and paid by pass-through entities are deductible in computing non-separately stated taxable income or loss. As you’ll see, this distinction between non-separately and separately stated taxable income proves critical in implementation.
States have adopted two primary approaches to these tax workarounds: the “flow-through approach,” where owners receive state tax credits for their share of entity-level taxes, and the “exclusion approach,” which reduces owners’ state taxable income by the amount taxed at the entity level. Connecticut for example currently assesses a 6.99% PTE tax on the entity’s taxable income, and provides the entity’s owners a 87.5% credit of the taxes paid on their individual tax return (effectively capturing a portion of the federal tax benefit). California’s PTE regime levies a 9.3% tax with a full owner credit but limits excess credit carryforwards to five years before expiring.
Generally, the state taxable income subject to the PTE regimes includes all income, gain, loss, or deduction that flows through to a direct partner, member, or shareholder of the entity, including investment items like interest and dividends, capital gains and losses, and 1231 gains and losses. This broad definition of income subject to the SALT workarounds combined with the IRS Notice’s position that the PTE taxes are non-separately stated deductions opens the door for significant tax benefits for owners of investment partnerships.
The investment partnership opportunity
IRS Notice 2020-75 creates a significant opportunity for high-net-worth individuals who hold their investments (including brokerage accounts, rental properties, etc.) in investment partnerships (typically LLCs taxed as partnerships or Limited Partnerships). By making no distinction between business and investment partnerships, the Notice potentially allows purely investment vehicles to leverage the state passthrough entity tax to deduct state income taxes that would have otherwise been disallowed due to the TCJA’s SALT cap.
The interplay between the SALT workaround and the Alternative Minimum Tax (AMT) creates an unexpected advantage for those utilizing this strategy. Prior to the enactment of the SALT cap, many high-net-worth individuals in high-tax states were subject to the AMT because of their large state income tax deductions. When individuals deduct state tax payments it increases their alternative minimum taxable income, often triggering AMT liability. However, by paying the state taxes through the state PTE workarounds and deducting the taxes at the entity level rather than in the individual tax return, the AMT addback is eliminated at the individual level. This not only preserves the federal deductibility of state taxes but actually improves upon the pre-SALT cap environment by allowing state tax deductions without corresponding AMT exposure.
Legal framework and technical analysis
The legal foundation for investment partnership SALT deductions rests on the IRS Notice, the TCJA House Ways and Means Committee Report accompanying the associated SALT cap, and several complementary arguments. At the heart of this framework is IRS Notice 2020-75, which provides the primary authority for allowing investment partnerships to deduct state income taxes at the entity level.
A critical aspect of Notice 2020-75 is its treatment of the state tax payment as a non-separately stated item. Separately stated items are passed through directly to partners for use on their own returns and then considered under the rules applicable to the individual. Non-separately stated items are included in the partnership’s determination of its taxable income and passed through to its partners as a net number. For example, interest, dividends and capital gains are separately stated items, each appearing on the partner’s Schedule K-1 as a separate number, whereas income and expenses associated with a business are non-separately stated, appearing on the partner’s Schedule K-1 as a net number.
The practical effect is significant—if the PTE tax paid was a separately stated item, it would be reported separately in the partner’s Schedule K-1. It would accordingly be reported as an itemized deduction on a partner’s individual income tax return’s Schedule A, subject to the $10,000 SALT limitation (and an AMT addback if the SALT limitation did not exist). Rather, as a non-separately stated item, the deduction reduces the net income reported by the partner on their individual return’s Schedule E, bypassing the SALT cap without increasing the individual’s alternative minimum taxable income.
Congress delegated to the IRS the authority to classify partnership items as either separately stated or non-separately stated (in Internal Revenue Code Section 702(a)(7)). In the context of SALT deductions, the IRS in Notice 2020-75 takes the position that no substantive statutory justification is required for calling a payment of an entity-level tax a non-separately stated partnership item. Furthermore, the IRS does not distinguish between business and investment partnerships in the Notice. Accordingly, a plain reading of the Notice indicates that even if a partnership is solely an investment vehicle and not engaged in a trade or business, it can still take advantage of the entity-level deduction for state taxes.
The IRS’s position draws strength from congressional intent, specifically referenced in a footnote to the House Ways and Means Committee report on the TCJA. This report states that entity-level taxes are to remain deductible, indicating that Congress did not intend the SALT cap to apply to taxes imposed at the partnership level.
Several arguments have been raised questioning the deductibility of state taxes by investment partnerships. However, careful analysis illustrates why these challenges don’t prevail under the currently available guidance.
Section 164(b)(6) of the IRC, which established the $10,000 SALT deduction limit, is clearly limited to an individual’s deductions; it doesn’t change the law for partnerships and S-corporations. Pursuant to the Notice, the entity-level tax reduces partnership income directly, rather than functioning as an individual deduction. Again, this distinction is crucial—the reduction occurs before the income reaches the individual partner’s return, placing it outside the scope of the Section 164(b)(6) limitation applied to individuals.
Some practitioners have argued that deductions appearing above the line on Form 1065 (the Partnership Tax Return) must qualify as trade or business expenses. However, the IRS has taken a broader view in the Notice, stating that no specific statutory justification is required to classify entity-level taxes as non-separately stated partnership items. The IRS had an opportunity to define the “Specified Income Tax Payment” for which the deduction is permitted and chose not to restrict the definition based on the activity undertaken by the partnership. This position is particularly significant for investment partnerships, which might not engage in traditional trade or business activities.
The treatment of these deductions also intersects with passive activity considerations. Under Treas. Reg. Section 1.469-2T(d)(2)(vi), state and local income taxes are specifically not passive activity deductions. Furthermore, for partnerships earning only portfolio income, the passive activity loss rules don’t apply at all. This is reinforced by Section 469(e)(1)(A)(i)(II) and Treas. Reg. Section 1.469-2T(d)(2)(i), which establish that deduction items clearly allocable to portfolio income are not passive activity deductions.
The question of separately stated versus non-separately stated items, governed by Section 702(a) and its regulations, presents interesting complexities. Treas. Reg. Section 1.702-1(a)(8)(ii) requires any item that would change a partner’s tax result if it had been broken out as a separately stated item to be reported as a separately stated item. Since the TCJA capped SALT deductions at the individual level, this regulation would naturally indicate that SALT payments made at the entity level should be separately stated so that the SALT cap could apply at the individual level. This would be the case regardless of the activity engaged in by the partnership (business, investment, etc.).
However, to comply with the legislative intent outlined in the House Ways and Means Committee report on the TCJA and with its own Notice, Treasury will need to modify this regulation to classify entity-level state taxes as non-separately stated items. The fact that Congress intended for the cap to not apply to payments made by passthrough entities, combined with the IRS’s authority to classify items as non-separately stated under Section 702(a)(7), and that the IRS took such a position in the Notice, provides strong support for the full deductibility of SALT taxes irrespective of the activity carried on by the partnership.
Implementation and best practices
Successful implementation requires attention to several key elements. The IRS could presumably apply the economic substance doctrine along with other mechanisms to attack the PTE tax deductions associated with investment partnerships. The IRS has consistently prevailed in the courts challenging taxpayers’ claimed deductions where legitimate, non-tax business purposes were absent. Accordingly, it is essential to establish and document legitimate non-tax purposes for the partnership structure. Courts have consistently recognized various valid purposes through significant cases, mostly in the case of Family Limited Partnership structures.
Estate of Purdue v. Commissioner validated asset consolidation and coordination as legitimate non-tax motives. Estate of Shurtz v. Commissioner affirmed creditor protection and efficient management as valid purposes. Estate of Miller v. Commissioner recognized investment philosophy continuation, while Estate of Stone v. Commissioner validated family asset maintenance and equal distribution among heirs to be legitimate purposes for forming investment partnerships.
It is also essential that proper partnership formalities are maintained through the establishment of separate bank accounts, maintaining accurate records, bookkeeping, and capital accounts. Operating agreements associated with the entity should be drafted and respected by the partners, and the general partner(s) or manager(s) should hold and document management meetings and ensure their investment activities align with the stated purposes and philosophy in the partnership agreements.
A trap for the unwary: inadvertent application of the investment company rules
Contributing appreciated assets (like stocks) to a partnership normally avoids gain recognition. However, IRC Section 721(b) requires partners to recognize gain on their contributions when the transfer results in portfolio diversification and the partnership qualifies as an investment company.
A partnership becomes an investment company when over 80% of its assets are cash, stocks, securities, or similar investments. However, three key exceptions preclude gain recognition:
Identical Portfolios: Partners contributing identical portfolios don’t trigger diversification.
Insignificant Non-Identical Assets: Minor non-identical contributions are disregarded. For example, if two partners contribute $10,000 each in identical securities while another contributes $200 in different securities, the small amount is ignored.
Already-Diversified Portfolios: Partners contributing portfolios that each meet both the 25% test (no single issuer exceeds 25% of value) and 50% test (no five issuers exceed 50% of value) avoid gain recognition.
The IRS examines the entire transaction. If transfers are part of a plan to achieve tax-free diversification through multiple steps, the original transfer triggers recognition despite individual steps qualifying for nonrecognition.
Government securities receive special treatment, counting toward total assets without being considered a single issuer, unless acquired solely to avoid these rules.
Words of caution
While IRS Notice 2020-75 generally endorses state PTET workarounds, investment partnerships face heightened scrutiny and potential challenges from the IRS. The agency may question whether these entities can legitimately claim PTET deductions, particularly given the investment-focused nature of their activities and certain regulatory inconsistencies.
The IRS could challenge investment partnership PTET deductions on several fronts, beginning with the fundamental question of statutory justification. Investment partnerships typically lack traditional business expenses that would support deductions under Section 162 of the Internal Revenue Code, which practitioners generally view as the underlying basis for PTET deductions. The IRS might argue that everything deducted above the line on Form 1065 must qualify as a legitimate trade or business expense, and the agency cannot simply transform an otherwise nondeductible cost into a business deduction through administrative guidance.
Historical precedent supports this concern. Under Revenue Ruling 2008-39, state income tax on investment income paid by investor partnerships was treated as a miscellaneous expense, which became nondeductible for partners following the Tax Cuts and Jobs Act. The IRS could argue that Notice 2020-75’s drafters failed to consider partnerships not engaged in active trade or business activities.
The agency might also express concern about fairness implications, noting that allowing sophisticated investors to circumvent SALT caps by placing securities in partnerships could create advantages unavailable to less sophisticated individual taxpayers.
A second major challenge involves existing regulations governing separately stated items. Current IRS regulations require partnership-level taxes to be separately stated items when passing them through would alter a partner’s tax result due to TCJA limitations. However, Notice 2020-75 directly contradicts this requirement by stating that Specified Income Tax Payments do not constitute separately stated items and instead should be reflected in non-separately stated income.
This creates an unusual situation where IRS guidance appears to violate the agency’s own regulations. While the notice acknowledges this conflict and promises regulatory changes, those promised regulations have never materialized, leaving the legal foundation uncertain.
The IRS might also challenge the fundamental validity of Notice 2020-75 itself. Some tax practitioners have questioned whether the notice contravenes the plain text of the Internal Revenue Code, particularly the separate statement requirements under Section 702. The failure to issue the promised proposed regulations mentioned in the notice raises additional concerns about its legal foundation.
Most troubling, the notice states that reliance on its provisions applies only prior to the issuance of proposed regulations. Some analysis suggests this limitation should have ended reliance on November 9, 2020, potentially leaving subsequent PTET payments without assured favorable treatment.
Finally, the IRS could argue that state entity-level taxes function more like withholding taxes when accompanied by corresponding owner-level benefits such as credits or exclusions. Under this theory, the partnership pays tax on behalf of partners rather than incurring a deductible business expense, which would subject the payments to individual SALT limitations rather than allowing partnership-level deductions.
These potential challenges create significant uncertainty for investment partnerships currently utilizing PTET strategies. While many practitioners continue to advise clients that these arrangements remain viable under Notice 2020-75, the regulatory inconsistencies and lack of promised guidance create audit risks that investment partnerships should carefully consider.
Conclusion
The SALT cap workaround through investment partnerships offers sophisticated investors in high tax states a powerful planning opportunity that requires careful attention to structure and documentation. Success depends on balancing tax efficiency with legitimate business purposes, proper planning, and careful attention to partnership formalities.
As we approach the scheduled expiration of this limitation, investors should stay abreast of the developments concerning new federal tax legislation extending the cap’s expiration, Treasury regulations, rulings, and notices, along with the associated state PTE tax laws. For those willing to invest in proper structuring, the benefits extend beyond mere tax savings to create comprehensive vehicles for productive investment management, income tax efficiency, and potential estate planning opportunities.
This Toplitzky&Co publication provides information and comments on tax issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide tax advice. Readers should seek specific tax advice before taking any action with respect to the matters discussed herein.
Citations
Internal Revenue Code Section 164(b)(6)
Internal Revenue Code Section 702(a)(7)
Internal Revenue Code Section 721(b)
Internal Revenue Code Section 469(e)(1)(A)(i)(II)
IRS Notice 2020-75
Revenue Ruling 2008-39
Treasury Regulation Section 1.469-2T(d)(2)(vi)
Treasury Regulation Section 1.469-2T(d)(2)(i)
Treasury Regulation Section 1.702-1(a)(8)(ii)
Estate of Purdue v. Commissioner
Estate of Shurtz v. Commissioner
Estate of Miller v. Commissioner
Estate of Stone v. Commissioner
House Ways and Means Committee Report on the Tax Cuts and Jobs Act
One Big Beautiful Bill Act (OBBBA), enacted July 4, 2025