No Trade or Business Required

Why you should read this. For high-income single and joint filers already at the floor, the SALT cap is $10,000: the $40,400 limit for 2026 phases out entirely at about $606,333 of modified AGI, and most fund principals and carry recipients are above that. The House-passed bill of May 2025 would have cut investment partnerships out of the pass-through entity tax; the Senate struck it, the enacted law contains none of it, and New York’s attempt to trim its credits died in April. Whether the partnership is in a trade or business is the wrong question; whose tax it is, is the right one. Elect at the GP entity by March 15, 2027. The election form does not ask what your partnership does. Neither does §164(a)(3).¹ A Technical Companion, distributed with this alert, carries the reporting walkthrough, the allocation exhibits, and the answers to the objections.

State income tax on carried interest and on a principal’s share of fund gains is real money (10.9% in New York, 3.876% more in the City, 13.3% in California), and since 2018 the cap has denied a deduction for nearly all of it when the owner pays it personally. The pass-through entity tax (“PTET”) was the states’ answer: let the partnership pay the tax, give the partner a credit, and let the partnership deduct what it paid. Most states with an income tax now offer one.² Operating businesses adopted it within a year. Investment partnerships hesitated, and the hesitation has a respectable source: a partnership that only invests is generally not in a trade or business under Higgins; its management fees and similar costs are §212 items separately stated on the K-1, and an individual cannot deduct those at all under §67(h) (formerly §67(g)). So the instinct runs: is the fund’s PTET just another §212 item, separately stated, and lost?

It is not. Nothing in §164(a)(3), §703(a), Treas. Reg. §1.702-1(a)(8), or Notice 2020-75 conditions the partnership-level deduction for a state income tax on the partnership being in a trade or business. A state income tax is a §164 tax, not a §212 expense. The deduction turns on whose tax it is. Congress looked at exactly this question in May 2025, drafted the language that would have changed the answer, and left the notice standing.

Executive summary

Our clients sit at a $10,000 cap. For 2026 the §164(b)(7) limit of $40,400 phases down by 30% of MAGI over $505,000 and reaches the floor at about $606,333; separate filers reach a $5,000 floor at about $353,833 (Section 01).

A state income tax is a §164 item, not a §212 expense. The texts that govern the partnership’s deduction impose no trade-or-business condition; Notice 2020-75 supplies the administrative treatment the analysis relies on (Section 03, Exhibit 1).

Congress looked at this in 2025 and left the notice standing. State eligibility requires a separate analysis: New York and Illinois can admit investment partnerships, California applies its own doing-business test, and some states exclude investment partnerships outright (Sections 04–05).

Elect at the GP entity. Pay estimates under the state’s safe-harbor rules, get the balance in by December 31 for the deduction year, and allocate the expense to the members who bear it under an agreement that satisfies §704(b) (Section 06).

The numbers. Riverside’s two members save $43,198 each on $233,500 of New York tax if the deduction offsets income taxed at 37%, and $23,350 each at 20%. Harbor GP III’s members save $419,158 or $226,572 on $1,132,860 of State and City tax. These are scenarios under stated assumptions, not floors (Sections 07–08).

Agree the substantive and reporting positions with the return preparer before making the election. Views among preparers range from routine acceptance to refusal, and the reporting mechanics are not settled by any form instruction (Sections 01 and 09).

01 The $10,000 floor is where our clients live

Section 164(b)(6) caps an individual’s deduction for state and local income, property, and elective sales taxes at the “applicable limitation amount.” Section 164(b)(7), added by the 2025 Act (P.L. 119-21 §70120), sets the amounts. For 2026, the individual SALT cap is $40,400 for single and joint filers. It is reduced by 30% of modified AGI above $505,000, reaching a $10,000 floor at approximately $606,333. Married individuals filing separately have a maximum cap of $20,200, a phaseout beginning at $252,500, and a $5,000 floor reached at approximately $353,833; the 30% phasedown runs against the unhalved $40,400 before the separate-filer halving, which is why the floor arrives $101,333 above the threshold for both filing statuses. Beginning in 2030, the cap is $10,000, or $5,000 for married individuals filing separately. Compute post-PTET MAGI first, then the cap; an entity-level deduction that lowers MAGI can lift the cap for other SALT, while Schedule A taxes do not feed back into AGI. Where the member itemizes, the 2025 Act’s §68 limitation on the value of itemized deductions for 37%-bracket taxpayers also applies.

One feature of the cap matters for what follows. Its trade-or-business exception reaches only real property taxes and personal property taxes, the taxes described in §164(a)(1) and (2): the flush sentence exempts taxes “described in paragraph (1) and (2) of subsection (a) which are paid or accrued in carrying on a trade or business or an activity described in section 212,” along with foreign income taxes. For individuals, §164(b)(6) does not exempt state income taxes merely because the underlying income came from a trade or business. Trade-or-business status has never been the way out for income taxes. The cap is a limit “in the case of an individual”; a partnership’s deduction is governed by §703, and that is where the analysis belongs.

One caution before the argument. A leading tax practitioner who reviewed a draft of this alert cautioned that some accounting firms do not agree that this is even a reporting position. Views among preparers range from routine acceptance to a refusal to sign. Agree the substantive and reporting positions with the return preparer before making the election; the election is irrevocable in New York after the first estimated-payment due date, and the return is filed a year later.

02 Where the trade-or-business worry comes from

Managing one’s own investments is not a trade or business (Higgins v. Commissioner, 312 U.S. 212 (1941)), and Rev. Rul. 75-523 applied the rule to an investment club partnership: its expenses are §212 items. Section 703(a)(2)(E) denies the partnership the Part VII deductions, where §212 lives; Treas. Reg. §1.702-1(a)(8)(i) makes partners take “nonbusiness expenses as described in section 212” separately; Rev. Rul. 2008-39 applied that to a fund-of-funds management fee; and §67(h), made permanent by the 2025 Act, makes those deductions worth nothing to an individual. The catch-all in Treas. Reg. §1.702-1(a)(8)(ii) then adds that any item must be separately stated if separate treatment would change any partner’s tax. Put together, the worry is that a fund’s state tax is one more §212 item, separately stated and lost.³

03 Why it does not matter: no trade-or-business condition

The mistake is treating a state income tax as a §212 expense. It is a §164 tax, and the Code keeps the two in separate boxes. Section 164(a)(3) allows “State and local, and foreign, income, war profits, and excess profits taxes” without a trade-or-business condition; the business test in its flush sentence is confined to “taxes not described in the preceding sentence.” Section 703(a)(2) lists the deductions a partnership cannot take, and the only §164 taxes on the list are the §901 foreign taxes; §212 sits in Part VII and is disallowed by (a)(2)(E), §164 sits in Part VI and is not. Treas. Reg. §1.702-1(a)(8)(i) lists the items a partner must take into account separately, among them “nonbusiness expenses as described in section 212” and amounts paid to cooperative housing corporations under §216; foreign taxes are handled separately, under paragraph (a)(6). State income taxes appear in neither list, and a §164 tax is not a §212 expense. Section 67(b)(2) confirms that the Code has always kept the two apart.

Notice 2020-75 then defines the deduction by whose tax it is. The notice’s operative definition, in §3.02(1), focuses on the entity’s liability for the state or local income tax and its payment of that tax: a Specified Income Tax Payment is “any amount paid by a partnership or an S corporation to a State . . . to satisfy its liability for income taxes imposed by the Domestic Jurisdiction on the partnership or the S corporation,” and the definition applies “without regard to whether the imposition of and liability for the income tax is the result of an election by the entity or whether the partners or shareholders receive a partial or full deduction, exclusion, credit, or other tax benefit.” Its background, §2.02(3), describes the state laws it has in view as those taxing entities that do business in the jurisdiction or have income derived from sources within it; that is description, not a separate federal eligibility condition. The state must actually impose its income tax on the entity, and state-law eligibility and nexus require their own analysis.⁴

Swipe sideways for the other columns.

Exhibit 1. Who asks whether the partnership is in a trade or business. Source: statutes, regulations, rulings, and guidance as cited; La Presa analysis.

Section 3.02(3) says the payment “does not constitute an item of deduction that a partner . . . takes into account separately under section 702” and “will be reflected in a partner’s . . . distributive or pro-rata share of nonseparately stated income or loss.” Section 3.02(4) says it “is not taken into account in applying the SALT deduction limitation to any individual who is a partner.” Section 4 says taxpayers “may rely” on the notice. That is reliance guidance, not a regulation; the regulation’s enumerated list does not by itself settle every investor-partnership reporting question, and it is the notice that supplies the administrative treatment on which this analysis relies.

04 Whose tax is it?

The serious objection to the PTET is substance: the entity-level tax is a substitute for the partner’s own tax, so it should be treated as the partner’s. Treas. Reg. §1.164-1(a) allows a tax deduction “only by the person upon whom [the tax is] imposed,” and the state statutes impose the PTET on the entity; New York’s Article 24-A says the tax “is imposed on” the electing entity’s PTE taxable income, and California’s §19910 lets a qualified entity elect to pay an elective tax. The Service had said so twice before the notice. Rev. Rul. 58-25 allowed a Cincinnati net-profits tax to the partnership. Rev. Rul. 71-278 allowed an Indiana gross income tax “in computing the taxable income of a partnership and the distributable shares of the partners,” held that it “is not allowable as a deduction to the partners,” and added that the partners could still claim the standard deduction: the deduction reduces the distributive share and never becomes an itemized deduction of the individual. Both involved business-tax facts. We read their entity-level reasoning, together with §164, §703, and Notice 2020-75, as supporting the position here; the extension to a securities fund is ours, and neither ruling decides it.

Then came 2025. The House-passed bill (H.R. 1, May 22, 2025) created a new §275(b) regime of “specified taxes,” required them to be separately stated under a rewritten §702(a)(6), denied the partnership deduction under a rewritten §703(a)(2)(B), and preserved entity-level deductibility only for taxes paid by a “qualifying entity” deriving 75% of gross receipts from a §199A qualified trade or business. KPMG’s Santamaria and Palmer wrote in Tax Notes Federal that under that text “PTET regimes would generally be unavailable for taxpayers regarding SSTB and investment activities, and often also for QTB activities.” The Joint Committee’s description of the Chairman’s amendment put it plainly: “The proposal thereby abrogates IRS Notice 2020-75.”⁵ To exclude funds, the House drafted new definitions, a new separate-statement rule, and a new partnership-level disallowance. The Senate dropped the regime; P.L. 119-21 §70120 amends the cap and does nothing else. That history is context for the notice’s standing, not a holding. New York’s spring 2026 one-house budgets proposed cutting the credits: the Senate resolution would have limited the State credit to 90%, and both houses would have limited the City credit to 75%. Asked on April 28 whether reducing the credit amounted to a personal income tax increase, Governor Hochul was reported to have answered, “It’s not happening,” and to have added, “We’re not changing PTET.” The enacted FY2027 budget adopted neither reduction.

05 State eligibility is a separate test

Swipe sideways for the other columns.

Exhibit 2. State PTET regimes for investment and carry partnerships. New Jersey (5.675%/6.52%/10.9%, refundable credit) requires an annual election by the original return due date, on file before the Division will accept payments. Connecticut (6.99%) and Massachusetts (5%) cap the owner credit at 87.5% and 90%.⁶

California applies a separate state-law doing-business test, and it cuts the other way. R&TC §23101(a) reaches “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit,” and §23101(b) adds bright lines for California-organized or commercially domiciled entities and for sales, property, and payroll above indexed thresholds. A GP entity managed from Los Angeles is doing business in California even though it is not in a trade or business under Higgins; Swart Enterprises (2017) protects a passive 0.2% LLC investor, not the LLC being managed there. The federal test and the California test are different tests, and a “no” under one says nothing about the other.

Not every state admits an investment partnership, and the reason is state law rather than any federal test. North Carolina is the clean example: its rules treat a partnership whose only activity is as an investment partnership as not doing business in the State, so it has no North Carolina filing obligation, and its Department of Revenue answers the question directly: can an investment partnership make the Taxed PTE Election? “No.” That is a nexus and filing-obligation rule, not a §162 condition, and a fund with North Carolina business activity can fall outside the carve-out. Check eligibility state by state before assuming New York’s answer travels.⁷

Substance, not label, decides whether a levy is a §164(a)(3) income tax. New York’s and California’s are, measured by the owners’ income and imposed on the entity. Massachusetts styles its 5% levy an “excise” (Mass. Gen. Laws ch. 63D, §2); the label alone does not deny income-tax treatment, but characterize any unfamiliar regime from its operative provisions before treating it like New York. The base follows residency and source, and both follow the partner: New York taxes a resident partner’s full share and a nonresident’s New York-source share, and Tax Law §632(a) sources a nonresident partner’s items by what the partnership earned. “Carry” is not a sourcing category. Design the election around the cap table, with a documented sourcing conclusion for each nonresident.

The operating rule. A state income tax is deductible by the person on whom it is imposed. When a state imposes its PTET on the partnership and the partnership pays it, the tax is the partnership’s §164(a)(3) deduction. The question is not “are we in a trade or business?” It is “does the state impose this tax on us, and did we pay it?”

06 Elect at the GP entity

Of the three partnerships that could elect, the management company is an operating business and usually already does; the fund’s cap table is dominated by tax-exempt, non-U.S., corporate, and upper-tier limited partners, so funds elect rarely. In New York and California, an otherwise qualified partnership is not disqualified merely because it has corporate or partnership owners; those owners’ shares do not enter the applicable elective base. Other states require their own eligibility analysis. The GP entity is different: an LLC taxed as a partnership, owned directly by the principals and a few trusts, whose income is the fund’s long-term gain allocated in respect of the carry (after §1061’s three-year test) and which enters the New York and California base in full for resident members. It elects, pays from carry proceeds or a tax distribution, deducts the payment in computing its own taxable income, and reports each member’s share of income net of the tax.

A GP entity that actually manages the fund may have a trade or business of its own under Dagres v. Commissioner, 136 T.C. 263 (2011). That is a reserve argument for an excise-styled levy or a future business condition, not the reason we elect, and we would not rewrite the operating agreement to get there; a separate file memo covers it. Two things follow, in the agreement and the calendar. The operating agreement should allocate the PTET expense to the members who bear its economic burden, ordinarily those whose credits it produces, in a way that satisfies §704(b), and should say how the payment is funded. And New York requires the election by March 15 of the year being elected, before anyone knows whether an exit will close: elect when the expected net benefit justifies the cash commitment, pay estimates under the safe-harbor rules (the lesser of 90% of the current year’s tax or 100% of the prior year’s, the prior-year test available only if the entity elected for the prior year, in four installments, without annualization), update the forecast each quarter, and plan the December payment separately for the deduction year. The operations are where money is lost; the Companion’s Parts E and F walk through capital accounts, departures, refunds, and the seven traps we see most.

07 Worked case: Riverside elects in New York

The parties are invented and the figures are rounded. Riverside Holdings LLC is a calendar-year, cash-method Delaware LLC taxed as a partnership. It holds a portfolio of marketable securities and does nothing else; it is not in a trade or business under Higgins. Its two members, Diane Marsh and Eli Kaplan, are New York State residents outside the City, each 50%, each filing single, each with ordinary taxable income that stays above the 37% threshold ($640,600 for 2026) after the deduction, and each already at the $10,000 floor.⁸ In 2026 Riverside realizes $3,000,000 of long-term gain and qualified dividends. An authorized person elected New York State PTET on March 10, 2026, the required estimates were timely paid, and the balance is paid by December 31, 2026.

The §862 schedule gives $137,000 on the first $2,000,000 and $96,500 on the next $1,000,000: $233,500, an effective 7.78%. The operating agreement charges the tax to the two members equally and allocates the federal deduction the same way; each receives a refundable IT-653 credit of $116,750 and adds back the credit claimed on IT-225 (modification A-219, which is measured by the credit rather than by the federal deduction). Riverside claims the entity-level federal deduction on the reliance position described in this alert. For a partnership holding only investment assets, the preparer must document the Form 1065, K-1, and owner-return treatment that implements that position; the Companion’s Part D sets out the walkthrough we use, from the entity return to Schedule E. The savings below assume an allowable current deduction outside the owner’s SALT cap, with the owner-level effect modeled at the stated marginal rate.

Swipe sideways for the other columns.

Exhibit 3. Riverside results. Unrounded, each member saves $43,197.50 at 37%. Each member claims a $116,750 State credit and an equal A-219 addition modification. The credit offsets the entity-level PTET economically; under these assumptions the incremental combined tax benefit is the federal saving shown. NIIT is excluded. Nothing in the computation asked whether Riverside is in a trade or business.

08 Worked case: Harbor GP III elects in New York State and City

Harbor Partners Fund III, L.P. is a Delaware private equity fund holding portfolio company stock for investment. Harbor GP III, LLC, a calendar-year, cash-method LLC taxed as a partnership, holds the 20% carried interest, and its three members are Ana Reyes (Manhattan, 50%), Ben Okafor (Westchester, 30%), and Claire Tanaka (Los Angeles, 20%). Each files single, has $1,500,000 of ordinary taxable income from Harbor Management LLC before the PTET deduction, is above $606,333 of MAGI, and already fills the $10,000 cap with property tax. In 2026 the fund sells two companies held more than three years, and the waterfall allocates $12,000,000 of long-term gain to the GP entity: $6,000,000 to Ana, $3,600,000 to Ben, $2,400,000 to Claire.

Assumptions. Harbor GP III elected New York State and City on March 10, 2026, through an authorized person; the required estimates were timely paid and the balance is paid in 2026; the entity makes no 2026 distributions and has no book-tax differences. Claire’s share is stipulated to be investment income not sourced to New York under Tax Law §632(a), a fact-specific conclusion to be documented, not a rule. Harbor GP III is managed from New York, and we stipulate that it is not doing business in California under the full §23101 test, so it makes no California election; the absence of an office or payroll alone would not settle that question. Assume the operating agreement validly charges the State PTET economically to Ana and Ben in the ratio 62.5%/37.5%, and the City PTET solely to Ana, with corresponding federal deduction allocations respected under §704(b). Claire bears none of those taxes, and the capital-account and distribution provisions give effect to those charges.

New York State. PTE taxable income is the resident pool, $9,600,000. The §862 schedule gives $137,000, $289,500, and $473,800 across the brackets: $900,300, an effective 9.38%. Ana and Ben bear it in proportion to their PTE taxable income, 62.5% and 37.5%: $562,688 and $337,612, each with a refundable credit for the same amount. Because the entity computes at its own brackets, the credit will not match a member’s own liability exactly; Ben settles a small residual on his personal return, behind the cap. New York City. Ana is the only city resident, so the city base is her $6,000,000 and the tax is $232,560. Ana’s ordinary taxable income after the deduction is $704,752.50, still above $640,600, so the 37% illustration holds for her; Ben’s is $1,162,387.50.

Swipe sideways for the other columns.

Exhibit 4. Harbor GP III results. Entity-level tax $1,132,860; federal saving $419,158 at 37% ($419,158.20 unrounded) or $226,572 at 20%. The last row is a 2026 change, not an ending balance, and the three measures move together only on the stated assumptions. Half-dollar allocations are rounded so the members’ shares sum to the entity totals. NIIT (up to $43,049 at 3.8%) is not counted.

Two members pay New York what they would have paid anyway and recover $419,158 from the Treasury that the cap would otherwise have kept; Claire, who bears no New York tax, is untouched. In 2030 the cap is $10,000, or $5,000 for a married individual filing separately; Harbor’s members are already at the floor, so their result is unchanged, while members who had a higher cap in 2026 gain more from electing. If New York later cut the City credit to 75% and the State credit to 90%, Ana would lose $58,140 of City credit against an $86,047 federal saving and $56,269 of State credit against $208,195, and would still be ahead. Run the same facts at 20% and the City leg reverses: a $58,140 credit haircut against a $46,512 federal saving is a net loss of $11,628. On this simplified model the election survives a credit haircut until the haircut reaches the member’s assumed federal rate, and state add-backs, credit usability, and payment timing can move that breakeven, so test it by member rather than assume it.

Rates, character, and reliance. The 37% illustration assumes a currently usable deduction that offsets ordinary taxable income. The 20% illustration uses a lower marginal-rate assumption. A zero incremental benefit is the specific downside case in which the payment is treated as owner-level SALT subject to a cap the owner already exhausts. A different character or reporting conclusion requires a fresh owner-level calculation; it does not automatically produce zero. The ordinary character is a position: the notice and Rev. Rul. 58-25 place the payment in non-separately stated income or loss, and we are aware of no authority that recharacterizes it, but the point is well supported rather than free from doubt. A 37% result requires ordinary taxable income that remains in the top bracket after the deduction, in the year the K-1 lands, on the member’s actual filing status; a retired principal, a carry-only trust, or a first-year partner may be a lower-rate case, though the label does not establish the rate. Each member also needs outside basis and §704(d) room for the loss, tested at year-end after distributions. NIIT at 3.8% is upside only where the loss is properly allocable to net investment income under Treas. Reg. §1.1411-4(f). On reliance: Section 4 of the notice gives express reliance authority for covered payments, and no regulation has followed in six years. That is not immunity from retroactive change or from challenges on scope, facts, or allocations; we would read any later guidance under its own effective-date and transition rules.

09 Five questions before you sign

If the answers are fuzzy, wait a day. The March 15 date is real, and a bad election is worse than a late conversation.

1. Which entity is electing, and why not the one above or below it? Which direct members are residents of the electing state, and who is a trust, a corporation, or an upper-tier partnership?
2. For each member, does ordinary taxable income stay in the 37% bracket after the deduction, on the member’s filing status? What is the marginal rate if not, and does the member have basis for the loss?
3. Is the state’s levy an income tax under §164(a)(3) in substance? For California, are we doing business under the full §23101 test, and who is consenting?
4. What did the fund earn, and how does each state source a nonresident member’s share of it? What day does the cash leave, and which year does the deduction fall in?
5. Has the return preparer agreed the substantive and reporting positions, from the Form 1065 line through the K-1 statement to the Form 1040 schedule, before the election is made?

Our take

For a carried-interest vehicle with resident members, the opportunity can be substantial. An incremental $1,000,000 in New York’s top entity bracket yields $40,330 if every dollar of the deduction offsets income taxed at 37%, and $21,800 at 20%; at California’s 9.3% rate, $34,410 or $18,600. In the examples above, no proposed credit reduction we have modeled comes near the assumed 37% rate that would flip the sign; at 20%, Connecticut’s existing 12.5% haircut takes more than half the benefit. The value comes from matching the right entity, the right owners, and the right payment year, agreeing the reporting with the preparer, and demonstrating the benefit on the members’ projected returns. Between now and year-end: confirm which elections exist, coordinate the remaining entity payments with the owners’ estimates and the intended deduction year, and calendar New York’s 2027 election for March 15.

The market keeps asking whether investment partnerships “qualify” for the PTET. Investment status alone does not end the discussion. The harder question, and the one we would put to any fund CFO reading this, is which vehicles should elect for 2027, and why the GP entity did not elect in 2025 if the facts supported it. Deferral is not alpha. Neither is a deduction left on the table.

Technical companion

The companion, distributed with this alert and available above, is written for tax staff and return preparers. It follows a dollar of tax from the Form 1065 through the K-1 to the individual return (Part D), sets out the allocation and capital-account mechanics and the departure and refund cases (Part E), lists the seven traps we see most (Part F), describes the file (Part G), and answers the contrary arguments one at a time (Part C).

Important notes

This client alert is for general information only. It is not tax, legal, investment, or accounting advice. Consult your own advisers before acting. Riverside and Harbor GP III use invented parties and rounded figures; confirm every fact and figure on the actual facts. Rates are those for taxable years beginning in 2026; developments after September 19, 2026 are not reflected. Exhibit 5 of the PDF (illustrative benefit per $1,000,000 of PTE taxable income) is a chart and appears in the PDF only.

Download the alert (PDF, 317 KB)

Download the technical companion (PDF, 230 KB)

This alert is for general information only and is not tax, legal, investment, or accounting advice. Consult your own advisers before acting. Carlos A. Schmidt, MBT, MBA, CPA · Managing Member · carlos@lapresallc.com · (917) 558-6393.