Under 2020 legislation, Maryland pass through entities (“PTEs”) such as partnerships and S-Corporations will now have an option for the entity to elect to pay Maryland state income tax instead of the tax being paid by the entity owner(s). This could allow for a substantial entity level federal tax deduction for those owners whose state tax deductions have been capped at $10,000, per year, under the Tax Cuts & Jobs Act of 2017 (TCJA), the so-called SALT tax cap.
- The election, which is annual, can be effective for tax years beginning in 2020
- The election would allow the Maryland income tax liability created by business income of Maryland PTEs to be paid and deducted by the business rather than being paid and potentially not deducted by the owners
- IRS Notice 2020-75, issued November 9, 2020, indicates that the PTE is afforded the state tax deduction in the year the payment is made – this will impact accrual basis taxpayers who may have assumed they could accrue said deduction
- PTE owners could see their federal tax reduced by approximately 2.5-3.3% of the business income allocated to Maryland through a PTE
- The Comptroller of Maryland will need to issue regulations on the various aspects of this law, which takes effect July 1, 2020 – some guidance was issued on September 14th, but more will be needed by year end
- Making this election may also create the need for accounting for this tax liability in the entity’s financial statements for 2020 and forward
- Maryland PTE owners will need to consider the election and alter their Maryland tax payments if the PTE will be paying the Maryland tax on their behalf
- One drafting issue is that for S corporations with nonresident owners may find that this election is not beneficial unless and until Maryland changes the law to allow the election to be made on behalf of nonresident owners
- The same drafting issue will require that partnerships with nonresident owners will need to amend their agreements to specially allocate the Maryland tax deduction to resident owners to achieve economic parity
Maryland PTE Taxation
Prior to this law change, Maryland PTEs allocated income to its owners and applied the Maryland apportionment percentage to that allocation. The owners of the PTE would then report that income on their individual Maryland income tax returns. This was true regardless of the owners’ Maryland residency status for business income allocable to Maryland. In fact, PTEs filing a Maryland return where business income was allocable to nonresidents of Maryland were required to withhold tax on such income. However, it was deemed to be withholding of tax on behalf of the nonresident owner, not a tax liability of the entity itself.
Tax Cuts and Jobs Act of 2017
When the TCJA was enacted, one of the more controversial aspects of the legislation, was the new $10,000 limit on the state and local tax deduction for individual taxpayers. As it relates to business income, for owners of PTEs, they were effectively no longer deducting the state liability they owed on PTE income. The effect of this change was to drive up the net effective federal tax rate for most taxpayers, especially those with substantial business income.
While federal rates were decreased and a qualified business income deduction was created, both of which drove down business owners’ federal tax rates, the lost SALT deduction was a hot topic. Several workarounds were discussed and developed, and the IRS attacked and defeated most of them. However, a deduction for state entity level tax on business income was still allowed. Some jurisdictions, including, Tennessee, Washington DC, and Texas, already had entity level taxes for partnerships and S corporations. Taking a cue from those states, several states enacted entity level taxation statutes for PTEs to effectively give back the SALT deduction on PTE business income for individuals filing in those states. Maryland now joins those handful of states.
With this new legislation, Maryland PTEs may elect to be taxed at the entity level. The rate charged will be the top marginal Maryland rate for individuals, plus the lowest applicable county tax rate (which is the same rate charged to nonresident members of Maryland PTEs) or the Maryland corporate tax rate for corporate owners of a PTE. The member would still be required to report their PTE income on their federal and Maryland return. However, they could take a credit on their Maryland return for taxes paid by the PTE on their allocable share of PTE income. If the PTE owner’s local tax rate is higher than the lowest rate, they would be responsible for paying the difference in tax with their individual return. This effectively means that Maryland is getting the same tax that they would have before this law change.
It seems likely that in order to be consistent with Maryland’s treatment of entity level taxes from other jurisdictions, such as DC, PTE owners will be required to “add back” the deduction to their individual tax returns in order to be allowed the dollar-for-dollar credit against individual income tax.
Income allocable to tax-exempt owners of a PTE, as well as a REIT owner of a PTE will not be taxed under this election. An owner of a PTE that is itself a PTE will not be eligible for having their income taxed at the lower tier PTE level. Instead, they will need to make their own election.
The tax due under this new law will not be allowed to exceed the distributable cash flow of the PTE, which is a term of art previously defined by the Comptroller as it relates to nonresident PTE withholding. It also appears that if the PTE does not pay the tax due after making this election, that Maryland can seek collection from the partners.
A related change included in this legislation is the expansion of a Maryland tax credit for owners of an S-Corporation that pays entity level tax to another state tax jurisdiction to now include partnerships as well. Examples would be a partnership that files a Maryland return that has business income in Maryland, as well as, Washington DC, Texas, Tennessee, etc.
One area that has not been specifically addressed by the law is parity for sole proprietorships and disregarded entities, such as those reported on Schedules C, E or F. When combined with pre-existing attributes of the Qualified Business Income (QBI) deduction and payroll tax considerations, the availability of a federal deduction for state income tax to PTEs, may be yet another aspect that pushes small companies, real estate owners, and farmers to reorganize their businesses into partnerships or S-Corporations.
The Comptroller of Maryland Has Provided Regulations and Guidance Around the Following Issues :
- How will the election be made? The election is made annually on Form 510.
- When will entity need to make the election? The election is due with the filing of Form 510 and is noted on Form 510D when making a payment.
- Will the 2020 election be for the entire year or just the period after July 1, 2020? The election is for the entire 2020 tax year.
- Does the election carryover when all the PTE interests are sold? Open issue.
- Will PTE estimated tax payments be required for 2020 and in future years? Estimates for the PTE level tax should be made with Form 510D and the box next to “Check here if electing to remit tax on behalf of resident members” should be marked.
- How do composite returns interact with this new election? Apparently, this election only applies to income allocable to resident members. Form 510D is also used to remit payments on behalf of nonresident owners of Maryland PTEs.
Final Thoughts While We Await Further Guidance
- Once the election can be made for 2020, adjust individual Maryland estimates and look at adjusting Q4 tax distributions from the entity to its owners
- Consider the need to accrue the entity level tax and the accounting needed to support the current and deferred provisions therein
- The IRS issued Notice 2020-75 on November 9, 2020 which confirmed that statutes like Maryland’s will be respected by Treasury and the deduction will be allowed at the entity level
Please feel free to call TRS CPA Group with any questions.