Expansion of the PTET Base for Maryland Resident Owners
As part of its fiscal 2026 budget legislation (H.B. 352), Maryland enacted a significant change to its elective pass-through entity tax (PTET) regime. Effective for tax years beginning after December 31, 2025, the PTET base for resident owners of electing pass-through entities will no longer be limited to Maryland-source income. Instead, resident owners will be subject to PTET on their full distributive or pro rata share of entity income, regardless of source. For nonresident owners, the PTET base remains unchanged and continues to apply only to Maryland-source income.
Fixing the Resident Mismatch
This change addresses a long-standing inconsistency in Maryland’s original PTET framework. Under prior law, Maryland residents were taxed on their full share of pass-through income, but the PTET could only be paid on the Maryland-source portion. As a result, resident owners received only a partial PTET credit on their Maryland returns, and the pass-through entity could deduct only the portion of state tax paid on Maryland-source income for federal purposes. By expanding the PTET base to include all income earned by resident owners, the new legislation allows entities to pay tax on the full amount subject to Maryland tax at the individual level, aligning the entity-level payment and the owner’s actual tax exposure. For nonresident owners, the PTET election remains limited to the Maryland-source income portion of their share of the entity’s taxable income.
S Corporation Risk—Special Allocations and the Single-Class-of-Stock Rule
While this change resolves the mismatch for resident partners and members, it introduces a potential federal compliance issue for S corporations. The election is an all or none proposition: either the election into the Maryland PTET is not made, or if made for all Maryland resident owners, the PTET applies to income from all sources. Because resident and nonresident shareholders would now be subject to PTET on different taxable income bases, the economic effect of the tax could vary between those two categories of shareholders.
For example, assume that an S corporation doing business in part in Maryland had a 50% Maryland resident shareholder and a 50% Maryland nonresident shareholder. The S Corporation elects into the Maryland PTET and pays $100 of PTET, with $70 representing the Maryland resident’s tax on all of their share of the entity’s taxable income and $30 representing the nonresident’s share. When allocating Maryland tax items for the year, they all should be split 50%/50% in accordance with each shareholder’s stock interest, such that each gets allocated 50% of the $100 of Maryland PTET. Unlike a partnership, an S corporation should not be making special allocations of tax items or special distributions that differ from the owners’ shares. If it does so, it risks having established two discrete classes of stock and violating the requirement for S corporation status that it have only “one class of stock” under IRC § 1361(b)(1)(D). That rule requires all shareholders to have identical rights to distributions and liquidation proceeds. If the IRS views the arrangement as creating a second class of stock, the entity’s S election could be jeopardized.
Possible Legislative Fix—Limiting Expanded Base to All-Resident S Corporations
One potential fix being considered is to limit the expanded PTET base to S corporations whose shareholders are all Maryland residents. Under this approach, only such S corporations would be permitted to pay PTET on all income. S corporations with mixed-residency ownership would remain subject to the original rule and pay PTET only on Maryland-source income for all shareholders. This would preserve consistent tax treatment across owners and avoid triggering federal consequences under the single-class-of-stock rule. Alternatively, the fix could be to allow an S corporation to make the PTET election but with a further option in the election being to have it applicable only to the Maryland-source income of all shareholders (as applied under prior law). Although not yet enacted, this fix has been publicly discussed, and it is hoped that it will be included in technical corrections legislation to retroactively revise Maryland PTET election options.
Next Steps for 2026 Planning
Pass-through entities with Maryland-resident owners, particularly S corporations, should evaluate their 2026 PTET elections in light of this rule change. Legislative fixes may arrive in a fall 2025 special session or the 2026 regular session, but entities should begin modeling the potential impact now to avoid unexpected federal consequences. Similarly, S corporations should be aware of this issue when considering PTET elections in other states so as not to inadvertently put their S corporation status at risk.