Effective July 1, 2020, a pass-through entity (a PTE) with Maryland-source income can elect to have its Maryland taxable income be subject to Maryland state and local income tax at the PTE level with respect to its individual Maryland resident owners. Maryland Tax–Gen. Section 10–102.1; Chapter 641 of the Laws of Maryland of 2020. The election is intended to circumvent the $10,000 limit on the federal deductibility of state and local taxes imposed by the Tax Cuts and Jobs Act of 2017 (the TCJA).
Prior to the TCJA, individual taxpayers generally were able to deduct all state and local income and property taxes as itemized deductions. The TCJA, however, imposed a deduction limit of $10,000 ($5,000 for a married taxpayer filing a separate return) for state and local income and property taxes for taxable years 2018 through 2025.
The TCJA limit on the deductibility of state and local taxes sparked numerous attempts by several of the high-tax states to provide individual taxpayers with ways to circumvent the $10,000 limit. One early proposal in several states would have allowed taxpayers to make “charitable contributions” to certain “charitable” entities in exchange for receiving a state tax credit. The states took the position that the individual taxpayer could deduct the charitable contribution for federal income tax purposes, essentially shifting the transaction from a payment of income tax to a charitable contribution. The IRS, however, quickly responded with guidance that would deny taxpayers a charitable contribution deduction for these payments, eliminating the viability of this approach.
As an alternative, some states, including Maryland, have been looking at an approach to enable their resident taxpayers to avoid the $10,000 deduction limit. This alternative approach is based on the fact that under current federal income tax law, state and local taxes paid at the PTE level (as opposed to the individual owner level) generally are permitted to be included among other deductions taken by the PTE in determining the PTE’s taxable income that “passes through” to the PTE’s owners.
The deduction of such taxes by the PTE thus reduces the PTE owner’s taxable income for federal income tax purposes, without the imposition of the $10,000 limit, which would have applied had such taxes been paid at the individual owner level. This alternative approach, which the IRS has not yet addressed, effectively shifts the state and local income tax burden from the individual level, where it is subject to the $10,000 limit, to the PTE level, where arguably such limit does not apply.
This approach is quite novel in that a PTE, as a pass-through entity, typically incurs state and local taxes only in limited situations – i.e., property taxes for property owned by the PTE, sales taxes incurred in transactions entered into by the PTE, and, in some jurisdictions, gross receipts taxes due from the PTE. In contrast, in most jurisdictions, income taxes generally are not paid by the PTE; instead, the taxable income of PTEs generally “passes through” the entity without the imposition of income tax at the PTE level, and instead is included as taxable income on the federal and state income tax returns of its owners. In the absence of statutory amendments, such as the one being implemented in Maryland, individual PTE owners effectively get the benefit of full deductibility for entity-level state and local non-income taxes, but are subject to the $10,000 limit for state and local income taxes.
For example, assume a taxpayer that is subject to Maryland’s highest state income tax bracket of 5.75% and its lowest local income tax bracket of 2.25%, for a total of an 8% Maryland income tax rate, is allocated $1,000,000 of Maryland-source taxable income from a PTE. Without Maryland’s new PTE legislation, the $80,000 of income taxes imposed on this PTE’s pass-through income at the individual owner level would be subject to the $10,000 limit, resulting in the PTE owner being entitled to a federal income tax deduction of only $10,000 of the $80,000 of state and local income taxes paid.
The key provision of the Maryland legislation permits a PTE to elect to shift the responsibility for payment of state and local income taxes from the individual owners to the PTE itself. Under the existing PTE rules, the PTE must pay tax on behalf its nonresident PTE owners, but cannot do so with respect to its Maryland resident PTE owners. Under the new PTE regime, the PTE can elect to pay the state and local income taxes on behalf of its resident owners as well. To the extent that the PTE pays such taxes, each applicable PTE owner can claim a tax credit on the owner’s individual Maryland income tax return for the owner’s proportionate share of the state and local income taxes paid by the PTE.
To return to our example above, if the PTE elects to pay Maryland state income tax at the PTE level on behalf of its resident owner, then the PTE’s taxable income for federal income tax purposes would be $920,000, because the PTE would get a deduction for the $80,000 of state and local income taxes paid on behalf of its owner. The PTE owner would take a credit on its Maryland individual income tax return against Maryland tax payable for that $80,000 already paid to Maryland on behalf of the owner by the PTE. Thus, the Maryland resident PTE owner realizes the benefit of a federal deduction for the Maryland income tax via the reduced taxable income reported to it by the PTE on the owner’s Schedule K-1 and avoids being taxed twice by Maryland via the credit against Maryland income tax for the tax paid by the PTE.
More guidance is expected as to the application of these provisions to tiered PTEs. Furthermore, at present, it is not entirely clear how or when the election will be made by a PTE. If no place else, guidance can be expected to show up on the instructions to the 2020 Maryland PTE returns.
Note also that the availability and functionality of this benefit remain subject to further federal legislation and guidance. On the one hand, House Democrats have introduced a coronavirus stimulus bill that would temporarily suspend the $10,000 limit implemented by the TCJA, rendering the Maryland legislation described here irrelevant for such period. On the other hand, the IRS could issue guidance (as it did in the case of the charitable contribution workaround) denying a federal-level deduction for state and local income taxes paid by a PTE. Consequently, while the legislation certainly offers some hope to Maryland resident owners of PTEs engaged in business in Maryland, whether this workaround will successfully avoid the $10,000 limit in the long run is yet to be seen.