When Congress rewrote the federal tax code in 2025 through the One Big Beautiful Bill Act, one of its most fought-over provisions was also one of the least understood: the cap on the federal deduction for state and local taxes, universally known as SALT. Lawmakers quadrupled the cap, delivering a headline win to high-tax states and their residents. Yet for businesses — and especially for the private equity, private credit, and real estate partnerships that dominate American finance — the more consequential outcome was something Congress chose not to do. It left untouched a state-level maneuver, the pass-through entity tax, that lets partnerships and S corporations sidestep the SALT cap almost entirely. The result is a system in which the cap that theoretically constrains deductions for state taxes barely binds on business income at all, and a debate over fairness, federalism, and revenue that has merely been deferred, not resolved.

What the SALT cap is, and why it has always been contentious

The state and local tax deduction is one of the oldest features of the federal income tax, dating to its inception in 1913. For more than a century, taxpayers who itemized could deduct the income and property taxes they paid to states and municipalities, on the theory that money surrendered to a state government is not truly available as income to be taxed again by Washington. Because high-income taxpayers in high-tax states claimed the largest deductions, the provision disproportionately benefited residents of places like New York, New Jersey, California, and Connecticut.

That changed with the 2017 Tax Cuts and Jobs Act, which for the first time imposed a $10,000 ceiling on the SALT deduction. The cap was among the most politically charged elements of that law. Supporters argued it curbed a regressive subsidy that mostly helped wealthy households and effectively forced low-tax states to underwrite the spending choices of high-tax ones. Opponents, concentrated in coastal states, countered that it amounted to double taxation and unfairly singled out their constituents. The cap raised substantial revenue that helped pay for the 2017 law's rate cuts, but it also became a perennial target for repeal, and its scheduled expiration set up a confrontation that finally came to a head in 2025.

What the 2025 law actually changed

The One Big Beautiful Bill Act resolved that confrontation with a compromise that pleased almost no one entirely. Rather than repeal the cap or let it lapse, Congress raised it sharply. For 2025, the ceiling jumped from $10,000 to $40,000, applied retroactively to the start of the year. For 2026 it rises to $40,400, and it is scheduled to increase by one percent annually through 2029. Then, in a fiscal sleight of hand common to recent tax legislation, the cap is set to revert to $10,000 in 2030. (Holthouse Carlin & Van Trigt, Bipartisan Policy Center)

The expanded cap is not available to everyone. It phases down for higher earners: once a taxpayer's modified adjusted gross income exceeds $500,000 in 2025 (rising to $505,000 in 2026 and by one percent per year thereafter), the $40,000 allowance is reduced at a 30 percent rate, though it never falls below the original $10,000 floor. (Thomson Reuters) The design is deliberately targeted at the upper middle class rather than the very wealthy, a nod to critics who complained that a straightforward repeal would have been a windfall for millionaires.

For a salaried professional in a high-tax state, the quadrupled cap is a meaningful tax cut. For the owners of pass-through businesses, however, the raised cap is almost a sideshow, because they have access to a far more powerful tool that Congress declined to disturb.

The pass-through workaround, explained

In the years after 2017, states devised an ingenious response to the SALT cap on behalf of their business owners. The mechanism, now adopted by the large majority of states that levy an income tax, is the pass-through entity tax, or PTET. Its logic is simple. A partnership or S corporation does not itself pay federal income tax; its profits "pass through" to the owners, who report the income on their personal returns. Ordinarily, the state income tax attributable to that business income would be paid by the owners individually — and therefore subject to the $40,000 SALT cap.

Under a PTET regime, the state allows the business entity to elect to pay the state income tax at the entity level instead. Because that payment is a business expense, it is fully deductible on the federal partnership or S corporation return, with no dollar limit. The owners then receive a corresponding state tax credit or income exclusion. The net effect is to convert a capped, and often unusable, individual deduction into an uncapped business deduction. (Green Trader Tax, Thomson Reuters)

The Treasury Department blessed this approach in guidance issued in 2020, and the workaround has since become standard practice. Critically, the 2025 law left it intact. As several advisers have emphasized, PTET elections still make sense even after the cap was raised, because the entity-level deduction is unlimited, because it reduces the income that flows through to owners for both federal income tax and, in many cases, self-employment tax purposes, and because it can lower exposure to the alternative minimum tax. (Thomson Reuters, J.P. Morgan Private Bank) For a partner in a large fund whose share of state taxes runs well into six or seven figures, the difference between a $40,000 cap and an unlimited entity-level deduction is enormous.

The restriction that almost happened

The most important part of the 2025 story is a provision that did not survive. Earlier drafts of the legislation contained language that would have curtailed the PTET workaround for a specific category of businesses: specified service trades or businesses, or SSTBs. This is a term of art in the tax code, introduced in 2017, that encompasses fields such as law, accounting, consulting, health, athletics, and — crucially — investment management and financial services. Had the restriction been enacted, the partners of private equity firms, hedge funds, private credit managers, and many real estate sponsors would have lost access to the entity-level deduction, while owners of manufacturing, retail, and other non-service businesses kept it. (Tax Foundation)

That distinction would have carved a deep line through the financial industry, because the people who run investment funds are precisely the professionals the SSTB rules were designed to capture. The proposal set off intense lobbying, and in the final legislation the SSTB restriction was removed. The law preserves the broad deductibility of PTET payments for pass-through businesses regardless of type, including service firms. (Bipartisan Policy Center via reporting, Warren Averett) For fund managers, this was arguably the single most valuable outcome of the entire SALT debate, and it received a fraction of the attention lavished on the headline cap figure.

Why this matters for credit, private equity, and real estate

The relevance to the funds at the center of American private capital is direct. These vehicles are almost universally organized as partnerships, and their sponsors and principals earn income that flows through to individual returns in high-tax states. The PTET workaround allows the management company and the fund partnerships to deduct state taxes at the entity level without limit, materially lowering the effective tax rate on carried interest, management fees, and other pass-through income.

There is a further wrinkle that makes PTET especially attractive to these businesses. When a partnership pays the state tax directly, that payment reduces the net income allocated to the partners not only for income tax but, in appropriate cases, for self-employment tax as well. State income taxes paid personally by an owner do not reduce self-employment income even when they arise from business activity. (Green Trader Tax) For general partners and active principals, that is an additional layer of savings on top of the federal income tax benefit.

The real estate sector, which relies heavily on partnership structures and operates across multiple states, has an added incentive to master the mechanics, because PTET rules vary considerably from state to state in how they treat nonresident owners, tiered partnerships, and the timing of elections. The interaction of PTET with the restored EBITDA-based interest deduction and permanent bonus depreciation — other features of the 2025 law — compounds the planning opportunities for capital-intensive, leverage-heavy businesses.

The case for the cap and against the workaround

The controversy over this arrangement is genuine, and both sides have serious arguments. Critics of the SALT deduction, and of the PTET workaround in particular, make several points.

First is cost. The SALT deduction is expensive, and the higher cap increases the revenue Washington forgoes. The PTET workaround compounds the loss, because it allows an essentially unlimited deduction for a category of taxpayers the cap was meant to constrain. Analysts across the political spectrum have noted that the workaround quietly erodes the revenue the cap was designed to raise, effectively nullifying it for business income while leaving it in place for wage earners.

Second is fairness. Because the benefit flows to owners of profitable pass-through businesses in high-tax states, it accrues overwhelmingly to high-income households. A wage earner who happens to live in the same state and pays the same marginal state rate cannot use the entity-level trick; only the business owner can. Critics argue this creates a two-tier system in which the wealthy and the self-employed enjoy uncapped deductions while ordinary employees remain subject to the ceiling.

Third is the integrity of the legislative bargain. The cap was a deliberate policy choice, enacted to help finance rate reductions and to limit a subsidy that Congress judged regressive. A workaround invented by states and tolerated by Treasury, critics contend, substitutes state improvisation for federal intent and undermines the coherence of the code. Some would prefer that Congress either repeal the cap honestly or enforce it uniformly, rather than maintain a nominal limit riddled with an exception large enough to swallow the rule.

The case for the workaround and against the cap

Defenders of the deduction and the workaround respond with arguments of their own, rooted in tax principle and federalism.

The most fundamental is the double-taxation objection. Income paid to a state government, they argue, is not income the taxpayer can spend or save; taxing it again at the federal level violates the principle that the same dollar should not be taxed twice by two sovereigns. On this view, the SALT deduction is not a loophole but a structural feature that prevents compounding tax on tax, and the PTET workaround simply restores for business income the treatment that was always appropriate.

A second argument concerns parity between business forms. C corporations have always been able to deduct their state income taxes without limit as an ordinary business expense. Before the workaround, pass-through businesses — which make up the vast majority of American enterprises — faced a $10,000 ceiling on the same economic cost, purely because of how they were organized. The PTET mechanism, defenders say, levels the playing field so that a partnership and a corporation earning identical profits in the same state bear comparable federal tax on their state tax payments. Denying the deduction only to service businesses, as the failed SSTB provision would have done, would have introduced a further arbitrary distinction with no clear policy justification.

A third argument invokes federalism. States, defenders note, have the sovereign right to structure their own taxes, and the PTET regimes were enacted through ordinary state legislation and validated by federal guidance. Punishing residents of states that choose to fund robust public services, they argue, penalizes legitimate state policy choices and pressures states to lower their taxes to conform to federal preferences.

Fiscal and distributional consequences

The practical consequences of the 2025 compromise fall into a familiar pattern. The higher cap and the preserved workaround together reduce federal revenue, adding to a deficit that is already the subject of intense concern — a tension explored in prior USTD coverage of the Federal Reserve's balance-sheet debates. The benefits are concentrated among higher-income households and the owners of profitable pass-through businesses, which is to say among precisely the constituencies that populate the private equity, private credit, and real estate industries.

At the same time, the distributional picture is more nuanced than a simple "tax cut for the rich" framing suggests. The phasedown of the raised cap above $500,000 of income deliberately limits the benefit of the individual cap increase for the very wealthy, even as the PTET workaround remains available to them through their businesses. The result is a code in which the route to the largest benefit runs through business ownership rather than personal itemized deductions — a structure that rewards the organizational sophistication that funds and their advisers possess in abundance, and that ordinary taxpayers do not.

The politics and the 2030 cliff

The most important feature of the current arrangement may be its impermanence. By scheduling the higher cap to expire and revert to $10,000 in 2030, Congress used a budgetary device that reduces the official ten-year cost of the law while guaranteeing another fight before the end of the decade. When 2030 approaches, lawmakers will again confront the question of whether to extend the higher cap, let it fall, or restructure the deduction entirely — and, inevitably, whether to revisit the PTET workaround that the 2025 law left alone.

That future debate will be shaped by the same coalitions that clashed in 2025. High-tax-state representatives of both parties will press to preserve or expand the deduction. Fiscal conservatives will point to the revenue cost. And the financial industry will once again mobilize to protect the entity-level workaround, particularly against any revival of the SSTB restriction that came so close to enactment this time. Because the workaround is now deeply embedded in the tax planning of virtually every pass-through business of scale, unwinding it would be disruptive and politically difficult — but its survival is not guaranteed, and the near-miss in 2025 demonstrated that it is squarely within the range of options Congress will consider.

What to watch next

Three developments deserve attention in the months ahead. The first is state-level activity: a handful of states still lack a PTET regime or have idiosyncratic rules, and further standardization or divergence will affect multistate funds. The second is any technical guidance from the Treasury or the IRS on the interaction of PTET payments with other 2025 provisions, which could expand or narrow the practical benefit. The third, and most consequential, is the early positioning ahead of the 2030 cliff, including any renewed proposals to limit the workaround for service businesses. For the funds whose economics depend on the deductibility of state taxes, the stakes of that eventual reckoning are large, and the lobbying that shaped the 2025 outcome offers a preview of the battle to come.

For now, the paradox stands: Washington raised the SALT cap with great fanfare, and for most business owners it hardly matters, because the workaround Congress declined to touch does far more. The headline was the $40,000 figure. The story was everything Congress left unsaid.

This article is intended as analysis and does not constitute tax, legal, or investment advice.

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