For all taxable years beginning after December 31, 2019, a pass-through entity (PTE) with Maryland-source income now can elect to be taxed at the PTE level (rather than the owner level) with respect to its owners on the PTE's Maryland-source income for Maryland state and local income tax purposes. Maryland Tax-Gen. Section 10–102.1. 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), which has hit high-state income tax states such as Maryland very hard.
A more detailed discussion of the PTE legislation, as originally enacted, can be found here and here. The recently passed Maryland Recovery for the Economy, Livelihoods, Industries, Entrepreneurs, and Families (RELIEF) Act, however, has made three major changes to the PTE legislation passed in 2020. Each is discussed in more detail below. In addition, the Maryland comptroller recently released Form 510, Pass-Through Entity Income Tax Return, and its instructions with updates from the prior year to provide for the payment of the new elective entity level tax.
A PTE can now elect to pay tax at the entity level on behalf of resident and nonresident owners
Prior to the passage of the RELIEF Act, a PTE could make an election to pay tax at the entity level only on behalf of its Maryland resident owners. As discussed in our prior alert here, the restriction on the election to Maryland resident owners raised two concerns: (1) first, if the electing PTE was a partnership, it likely was necessary to include special allocation provisions in the operative documents for the PTE in order to ensure that the benefits and burdens of such taxes were borne solely by the Maryland resident owners; and (2) second, if the electing PTE was an S corporation with resident and nonresident owners, the inability to include a special allocation provision resulted in significant economic distortions. The revised legislation no longer limits the PTE to making the election only with respect to Maryland resident owners; instead, the revised legislation provides that if the PTE makes the election to pay the entity-level tax, the PTE must pay the tax on behalf of all of its owners, whether resident or nonresident. As a result, the new legislation eliminates the need for any special allocations and opens the door for both partnerships and S corporations to make the PTE election without any added complexity or economic distortions.
A PTE considering the election and having Maryland nonresident owners still must be wary of the potentially adverse effect of the election on the nonresident owners. Depending on the tax rules of a nonresident owner's state, nonresident owners may find that their resident state does not allow a crediting of the Maryland entity-level tax against their resident state individual income tax. Thus, while they realize the benefit of a SALT deduction when determining their federal income tax, the cost potentially is having to pay state income tax twice on the same Maryland-source income without an offsetting credit.
A PTE can now elect to pay tax at the entity level on behalf of owners that are PTEs
Prior to the passage of the RELIEF Act, a PTE could not make the election to pay tax at the entity level with respect to income allocated to another, upper-tier PTE. Because of the distinction between individual versus entity owners, this restriction implicated the same concerns regarding the need for special allocations in partnership and limited liability company agreements. The changes made by the RELIEF Act not only alleviate these concerns, but now give a tiered entity structure "two bites at the apple." For example, assume a PTE (the "Lower Tier PTE") is owned by an individual and another PTE (the "Upper Tier PTE"). The Lower Tier PTE can make the entity-level election and pay Maryland income taxes on behalf of both the individual and the Upper Tier PTE. If the Lower Tier PTE does not make the election, the Upper Tier PTE could make the election with respect to both Maryland-source income allocated to it from the Lower Tier PTE and any Maryland-source income from other sources.
If a PTE pays tax on behalf of an owner, the owner must add back the payment to its Maryland-source income
After the passage of the initial PTE legislation in 2020, it was unclear whether, and how, Maryland would ensure that taxpayers did not get the benefit of the entity-level tax as both a credit against their Maryland individual income tax and a deduction that carries over from their federal return to the determination of their Maryland taxable income on their state return. As discussed in our prior alerts, the PTE election allows the PTE to pay tax at the entity level in respect of income allocated to its owners. This creates a deduction for state taxes paid at the federal level, reducing the amount of income allocated to the owner for purposes of determining the owner's federal tax liability. Because Maryland generally conforms to the calculation of income under federal law, in the absence of any sort of adjustment to the owner's Maryland return, the owner's share of flow-through income at the state level likewise would be reduced by the amount of the tax payment, giving Maryland taxpayers a double benefit.
As anticipated, the RELIEF Act provides that if a PTE elects to pay entity-level tax on behalf of its owners, each owner must comply with a "decoupling modification" that requires the owner to add back the amount of its share of the state taxes paid for purposes of determining Maryland-source income. For example, assume a PTE owner is allocated $100 of Maryland-source income, and the PTE pays Maryland tax at an 8% rate (i.e., $8 of entity-level tax) with respect to the income allocated to the owner. At the federal level, the PTE owner would be allocated $92 of income and would pay federal tax on this $92 of income. Without the decoupling modification, the owner would report $92 of income on its Maryland return while also getting to credit the entity-level tax directly against its Maryland income tax. Assuming the same 8% tax rate, this would result in Maryland tax due from the owner of $7.36, rather than the $8 paid on the owner's behalf. The function of the decoupling modification is to add back the $8 of tax paid to the $92 of federal income, such that the owner's Maryland tax is calculated based on $100 of income (resulting in $8 of tax in our example).