Saving federal income tax by paying a state Pass-Through Entity Tax for large gains

Selling something that has shot up in value — think appreciated stocks, bitcoin bought for pennies, a rental building, or a closely held business — can leave you staring at a hefty state and federal income tax bill.

Since 2018, the federal $10,000 cap on state-and-local-tax (SALT) deductions has made that sting even worse. Although the One Big Beautiful Bill Act passed in July increased this to up to $40,000 in some cases, this increased deduction starts to phase out quickly whenever a taxpayer’s income exceeds $500,000 ($250,000 for married filing separately).

A surprisingly simple workaround exists: let a pass-through entity (PTE) such as an LLC, partnership, or S corporation pay the state income tax directly through a State Pass-Through Entity Tax (PTET) program that qualifies as a State Income-Tax Payment (SITP) under federal guidance.

What is an SITP and why does it matter?

• SITP in plain English: Instead of you writing the check to the state, your eligible pass-through entity (typically an LLC or partnership) does.

• Federal treatment: The IRS (Notice 2020-75) says these payments count as an ordinary business deduction under Section 164 — even if the entity is not “running a business” in the traditional sense.

• Why that is important: The deduction happens above the SALT cap, so 100% of the state tax reduces the entity’s taxable income. When that income “flows through” to you, your federal bill already is lower.

Do I need an active trade or business?

For federal purposes, no. Although the IRS could change its policy and issue new regulations in this area, the current IRS directions in Notice 2020-75 focus on whether the payment satisfies the entity’s state income-tax liability, not on whether the entity sells widgets, rents apartments, or simply holds investments. Some states do require an active trade or business to opt in, but most — including Illinois and California — allow purely investment-holding entities to participate. Always check your state’s rules.

A quick example

• You sell appreciated stock and expect a $1 million state taxable gain.

• Form or use an existing LLC that has at least one other owner to create a partnership. This may be a spouse, a child, another corporation or partnership you control, or a non-grantor trust. You contribute the stock, then the LLC sells it.

• The LLC elects to pay the state’s PTE tax. It pays, say, $50,000 to the state. It files a partnership tax return, deducting the state estate tax paid on Form K-1. Estimated tax payments may need to be made quarterly throughout the year.

• Federal deduction kicks in. The $50,000 is fully deducted at the entity level, trimming the taxable income that reaches your personal return — no $10,000 SALT cap in the way.

• On your state income tax return, you receive a deduction or credit for the $50,000 state income tax that your entity paid for you.

• Bottom line: At a 37% federal rate, that deduction alone could save roughly $13,500 in federal tax.

Bonus for families with taxable estates

Moving the asset into an LLC before the sale can also set up valuation discounts (for lack of control and marketability) when gifting or leaving interests to your beneficiaries. Lower values mean smaller gift-and-estate-tax hits — stacking estate-planning advantages on top of the income-tax savings.

Key takeaways

• Any large-gain asset qualifies. Bitcoin, investment real estate, business interests, or legacy stock positions all work. (Primary homes often do not make sense because of the home-sale exclusion only afforded to individuals.)

• SITPs are federal Section 164 deductions. They sidestep the SALT $10K cap and the suspended miscellaneous-itemized-deduction rules.

• No trade or business needed federally under current IRS interpretation. But state opt-in rules may differ.

• Estate and asset protection planning sweetener: Holding assets in an LLC can unlock estate and gift tax discounts and improve protection from creditors.

• Andy Kelleher is a firm principal, and Ed Morrow is a senior attorney at Kelleher + Holland, LLC — a nationally recognized, full-service law firm with more than 70 legal professionals headquartered in North Barrington. Visit www.kelleherholland.com or check out the K+H YouTube channel for more easy-to-understand tips.