California’s Pass-Through Entity election lets partnerships and S-corporations bypass federal tax limitations and save up to $40,000 annually. Understanding eligibility requirements, filing deadlines, and calculation methods helps business owners reduce their state tax burden significantly.
You built a successful business. Your revenue keeps climbing and your team is growing. Then tax season arrives and you discover that despite paying over $30,000 in California state income tax, you can only deduct $10,000 of it on your federal return.
That $10,000 cap on state and local tax deductions—commonly called the SALT cap—has quietly drained thousands of dollars from business owners since 2018. The federal government limits how much state tax you can write off, regardless of how much you actually paid. For high-earning professionals in California's expensive tax environment, this cap stings.
But there's a workaround that many business owners still don't know about. The California Pass-Through Entity election lets you restructure where you pay state taxes, turning a limited deduction into a fully deductible business expense.
Here's what happens under the standard setup. Your S-corporation or partnership earns profit. That profit flows through to your personal tax return. You pay California state income tax on that profit at personal rates, which can reach 13.3% for higher earners. When you file your federal return, you try to deduct that state tax payment—but the SALT cap stops you at $10,000.
The rest of that state tax payment? It just vanishes from your federal deductions. You paid it, but you can't use it to reduce your federal taxable income. For someone paying $50,000 in California state tax, only $10,000 counts. The remaining $40,000 provides zero federal benefit.
This is where most business owners throw up their hands and assume nothing can be done. Tax laws are set in stone, right? Not quite. California introduced a solution in 2021 that changes the game entirely.
The Pass-Through Entity election shifts the location where you pay California state income tax. Instead of paying it on your personal return where the SALT cap applies, your business pays it at the entity level. Your S-corp or partnership files a special election and pays California state tax directly from business funds.
Here's why that matters. Federal tax law treats entity-level state tax payments differently than personal state tax payments. When your business pays state tax as a business expense, it's fully deductible against your business income. No $10,000 cap. No limitations. The full amount reduces your taxable income.
You're paying the same California tax you would have paid anyway. You're just paying it through a different door—one that doesn't have a bouncer limiting your federal deduction.
The mechanics work like this:
Let's run an example with actual figures. Say your S-corporation generates $500,000 in taxable income that flows to you. At California's top rate, you owe roughly $66,500 in state income tax.
Without PTE Election:
With PTE Election:
Same state tax paid. Different federal outcome. That's over $20,000 staying in your business instead of going to federal tax.
For businesses earning between $200,000 and $1 million in passed-through income, the savings typically range from $8,000 to $40,000 annually. The exact amount depends on your tax bracket and how much state tax you pay.
The PTE election works for partnerships and S-corporations. These are the pass-through entities where income flows to owners' personal returns. You can't use this strategy if you operate as a sole proprietorship, single-member LLC taxed as a disregarded entity, or C-corporation.
Ownership structure matters. Your entity must be owned by individuals, trusts, or estates. If another pass-through entity owns part of your business, that can create complications. Some ownership structures with multiple tiers need careful review to confirm eligibility.
California residency also plays a role. The election applies to California-source income. If you're a non-resident with California business income, you can still benefit, but the calculation gets more involved. Multi-state businesses need to allocate income properly.
The California PTE election operates on an annual calendar. You must make the election each year—it doesn't automatically renew. For 2025, the election deadline is March 15. Missing that deadline means you wait until next year to participate.
Estimated payments follow a specific schedule:
These dates differ slightly from standard quarterly deadlines. Mark them clearly on your calendar or set up automated reminders. Underpayment penalties apply if you miss dates or pay too little.
The election itself requires filing Form 3893 with California's Franchise Tax Board. Your tax preparer should handle this if you work with one. The form isn't complicated, but it needs to coordinate with your entity return and estimated payment calculations.
Many business owners elect without running projections first. The PTE election might not benefit everyone equally but if your business has losses, operates at break-even, or generates minimal income, the savings might not justify the administrative work. Run the numbers before committing.
Some businesses elect but fail to make timely estimated payments. California charges penalties and interest on late or insufficient payments. The penalties can eat into your federal savings if you're not careful. Set aside funds quarterly and pay on schedule.
Forgetting to claim the credit on personal returns happens more often than you'd expect. You paid the tax at the entity level, but you must still file a personal California return claiming the credit. Skip this step and you'll effectively pay California tax twice—once at the entity level and again personally because you never claimed the credit.
If you're paying more than $10,000 in California state income tax and you operate a partnership or S-corporation, the PTE election deserves serious consideration. Start by gathering your prior year tax returns. Look at your California state tax liability on your personal return. If that number significantly exceeds $10,000, you're likely leaving money on the table.
Next, verify your business structure and ownership. Confirm you operate as a qualifying entity without ownership complications that might disqualify you and check this year's election deadline and mark it clearly.
Finally, consult with a CPA who works regularly with pass-through entities, such as Bay Area-based . They'll run projections showing your potential savings and help you decide whether to proceed. The consultation usually takes less than an hour and provides clarity on whether this strategy fits your situation.
The PTE election won't work for everyone. But for qualifying businesses, it's one of the few legal strategies that directly counters the SALT cap's impact. Twenty thousand dollars in annual savings compounds quickly over five or ten years. That's capital you can reinvest in growth, save for retirement, or simply keep instead of handing to the IRS.
You built your business to create financial freedom. Make sure your tax strategy supports that goal instead of undermining it.
Yes, you can make the election even with out-of-state partners. The calculation becomes more involved because you need to separate California-source income from income earned elsewhere. Each partner's residency status affects how much credit they can claim on their personal California returns. Out-of-state partners still benefit from the federal deduction even if they don't pay California tax personally. Multi-state businesses should work with a tax professional to ensure proper income allocation and credit calculations.
If your business generates a loss after making the PTE election, you typically don't owe any entity-level tax. California won't collect payment on negative income. You still filed the election, but it becomes irrelevant for that tax year. Your business loss flows through to your personal return as usual. The election doesn't hurt you in loss years—it just doesn't help either. You can elect again in future profitable years.
No, the PTE election only affects income tax treatment. It doesn't change self-employment tax obligations for general partners or affect payroll tax calculations for S-corporation owners taking W-2 wages. You still owe the same Social Security and Medicare taxes you would have owed without the election. The benefit is purely on the income tax side, specifically the interaction between California state tax and federal deductions.
You base estimated payments on your projected entity-level California tax for the year. Take your expected pass-through income, multiply by the California tax rate applicable to that income, and divide into quarterly payments following the PTE schedule. Many businesses use the prior year's tax as a safe harbor to avoid underpayment penalties. If your income fluctuates significantly, you might need to adjust payments mid-year.
You want to work with a California-licensed CPA who regularly handles pass-through entity taxation for businesses. Look for professionals who understand both federal and California state tax rules, can model your specific savings scenario, and have experience filing PTE elections. Many offer free consultations to evaluate whether the election makes sense for your business.
