How are PTE's taxed for federal purposes?

Pass-Through Entities (PTEs) such as partnerships, S corporations, and LLCs (taxed as such) generally do not pay federal income tax at the entity level. Instead, income, losses, deductions, and credits flow through to the owners, who report them on their personal returns.

However, the One Big Beautiful Bill Act (OBBB), enacted on July 4, 2025, significantly altered the landscape for PTE owners starting with the 2025 tax year (returns filed in 2026) and beyond.

1. Introduction

For federal purposes, a PTE is a "reporting entity" rather than a "taxpaying entity." Its primary federal responsibility is to file an informational return (Form 1065 for partnerships/LLCs or Form 1120-S for S corporations) and issue Schedule K-1s to owners.

The owners then pay tax on this income at their individual rates (up to 37%, or lower if the OBBB tax bracket adjustments apply). The most critical federal components for PTEs are the Section 199A Qualified Business Income (QBI) deduction and the deductibility of state taxes (SALT), both of which were overhauled by the OBBB.

2. Core Explanation

A. The "Pass-Through" Mechanism

• No Entity Tax: The entity pays $0 federal income tax (with rare exceptions like S Corp Built-in Gains tax).
• K-1 Reporting: Net income is allocated to owners based on ownership % (S Corps) or the partnership agreement (Partnerships).
• Tax Year: Income is taxed to the owner in the year the entity's tax year ends, regardless of whether cash was actually distributed. Phantom income (taxable income without cash distribution) is a common trap.

B. Section 199A (QBI Deduction) – Major OBBB Updates

The 20% deduction on Qualified Business Income (QBI), originally set to expire in 2025, has been made permanent and enhanced.

• The Deduction: Owners can deduct up to 20% of their QBI, effectively lowering the top tax rate on business income.
• New Phase-in Thresholds: For 2026 and beyond, the income thresholds for the W-2 wage/property limitations have increased:
  • Single: Phase-in starts at **75,000** (previously ~50k base).
  • Married Filing Joint: Phase-in starts at **150,000** (previously ~100k base).
• New Minimum Deduction: A new "400 minimum deduction" applies to "applicable taxpayers" (those with >1,000 of active QBI) even if the standard calculation yields less.
• SSTB Rules: The limitation for "Specified Service Trades or Businesses" (doctors, lawyers, consultants) remains, subject to the new higher income thresholds.

C. State Tax Deductions & The SALT Cap

Historically, the $10,000 State and Local Tax (SALT) cap severely limited deductions for PTE owners.

• OBBB SALT Cap Increase: For tax years 2025–2029, the SALT cap has been increased to $40,000 (adjusted for inflation).
• PTE Tax (PTET) Election: Most states allow PTEs to pay state income tax at the entity level.
  • Federal Treatment: Per Notice 2020-75, these payments are fully deductible business expenses for the entity.
  • Impact: This bypasses the SALT cap entirely. Even with the new 40,000 SALT cap, the PTET election remains valuable for high-income owners whose state tax liability exceeds 40,000.

D. Owner Compensation & Self-Employment Tax

The tax treatment differs by entity type:

• S Corporations: Owners working in the business must take Reasonable Compensation (W-2 wages).
  • Tax Impact: Wages are subject to FICA (15.3%). Remaining profit is not subject to Self-Employment (SE) tax.
• Partnerships (and LLCs): Owners cannot be employees. They receive Guaranteed Payments or distributive shares.
  • Tax Impact: generally, all active business income allocated to a general partner is subject to SE tax (15.3%).

E. Loss Limitations

Before a PTE owner can deduct a loss, it must clear four hurdles (in order):

1. Basis: You cannot deduct more than your investment + debt basis (different rules for S Corp vs. Partnership debt).
2. At-Risk: You cannot deduct losses funded by non-recourse debt (unless qualified real estate financing).
3. Passive Activity (469): If you don't "materially participate," losses can only offset passive income.
4. Excess Business Loss (461(l)): Caps aggregate trade/business losses (indexed annually) against other income (e.g., wages, dividends).

3. Summary

• Entity Tax: Generally none; income flows to Form 1040.
• QBI (Sec. 199A): Permanent 20% deduction; phase-out thresholds raised to 75k/150k.
• SALT Cap: Increased to $40,000 for 2025–2029.
• PTET Election: Still the primary strategy for high-income earners to fully deduct state taxes federally (Notice 2020-75).
• Compensation: S Corps require W-2s; Partnerships use Guaranteed Payments.

4. Audit and Practitioner Considerations

The IRS frequently challenges PTEs on specific issues. Be prepared to defend:

1. Reasonable Compensation (S Corps):
   • Risk: Setting a $0 or low salary to avoid FICA tax.
   • Defense: Document how comp was determined (industry data, hours worked). "Distributions" taken in lieu of wages are a primary audit trigger.
2. Basis Verification:
   • Challenge: Partners/Shareholders deducting losses in excess of basis.
   • Requirement: Form 7203 (S Corp basis) must be attached to the 1040 if losses are taken or distributions received.
3. Material Participation:
   • Risk: Grouping "passive" investors as "active" to claim the full QBI deduction or deduct losses.
   • Documentation: Keep a time log proving >500 hours (or other tests) of participation.
4. PTET "Benefit" Analysis:
   • New Consideration: With the SALT cap now at 40,000, verify if the administrative cost of a state PTET election is still worth it for clients with state taxes *under* 40k.

5. Suggested Next Steps

• Review 2025 Returns: Ensure the new $40,000 SALT cap is applied (it is retroactive for the 2025 tax year).
• Re-evaluate PTET: Calculate if your state tax liability exceeds $40,000. If not, the complex PTET election may no longer be necessary.
• Check QBI Thresholds: Re-assess clients who were previously phased out of QBI; the new $150k (joint) threshold may bring them back in.
• File Form 2553: If S Corp taxation is desired for an LLC to mitigate SE tax, ensure the election is timely (by March 15 for calendar year entities).