December 14, 2020

Maryland Enacts Pass-Through Entity Tax as SALT Workaround

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No doubt somewhat overshadowed by the pandemic and massive amount of COVID-19 related legislation, but last week, Maryland joined six other states in passing legislation to offer at least some taxpayers relief from the restrictive $10,000 cap on individuals’ state and local tax (SALT) deductions. Preceding enactment, the Maryland Department of Legislative Services revised Fiscal and Policy Note provided that:

The Comptroller’s Office estimates the bill will reduce federal taxes by approximately $425 million for 139,000 households (although this estimate includes Schedule C income, which is not applicable to the bill).”¹

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On May 7, 2020, Maryland Governor Larry Hogan sent a letter to Bill Ferguson, the President of the Senate, stating that he was enacting numerous bills without his signature, including SB 523 – Income Tax—Pass-Through Entities and Corporations.² Significantly, the new law allows “a pass-through entity (PTE) to elect to be taxed at the entity level for the income tax.”³ The law is effective July 1, 2020, and applicable to tax year 2020 and thereafter.

Background

1. Basic Income Taxation: C Corp v. PTE

C corporations income are generally taxed twice—once at the corporate level and then again at the individual level when dividends are distributed to the owners or shareholders.  On the other hand, a PTE business structure avoids this double taxation, because the PTE income “flows through” and is allocated to the PTE owner(s). So, the PTE owner(s) pays the income tax at the individual level.

PTEs typically fit into one of five categories: (1) sole proprietorship; (2) general partnership; (3) limited partnership; (4) limited liability company; and (5) S corporation.

2. $10,000 SALT Cap

As we’ve described before, under Internal Revenue Code (IRC) §164, there are four categories of taxes which are deductible whether or not a trade or business, or for-profit activity exists.⁴  These taxes include:

  • State and local and foreign real property taxes;
  • State and local personal property taxes;
  • State and local, and foreign, income, war profits, and excess profits taxes; and
  • The generation-skipping transfer tax imposed on income distributions.

However, beginning in 2018 and effective through tax year 2025, the aggregate amount of the following categories of taxes able to be deducted is capped at $10,000 ($5,000 for married taxpayers filing separate returns):

  • State and local real property taxes (not paid or accrued in carrying on an IRC §162 trade or business or in an IRC §212 activity);
  • State and local personal property taxes (not paid or accrued in carrying on an IRC §162 trade or business or in an IRC §212 activity);
  • State and local income, war profits, and excess profits taxes; and
  • State and local general sales taxes. ⁵
3. States Look for a Workaround

Since taxes paid by entities are not subject to the SALT cap, several states have enacted PTE legislation—creating an entity-level income tax as a workaround—so that SALT can be deducted notwithstanding the cap. Besides Maryland, the other states with PTE legislation in effect, include:

  • Connecticut
  • Louisiana
  • New Jersey
  • Oklahoma
  • Rhode Island
  • Wisconsin

Thus far, the IRS has not issued formal guidance on any of these states’ PTE tax workarounds. And there are many practitioners and commentators who maintain that a PTE workaround could survive IRS scrutiny if the law is carefully and properly crafted.⁶

The New Law in Maryland

Senate Bill 523, Income Tax—Pass-Through Entities and Corporations, was enacted under Article II, Section 17(c) of the Maryland Constitution – Chapter 641. For PTE members, the new law creates a federal level benefit without a state revenue loss.

Again, the new law will revise Md. Code, Tax-Gen. §10-102.1(b)(2), so that a PTE may choose to be taxed at the entity level for the income tax.

As amended, Md. Code, Tax-Gen. §10-102.1(d)(3), will provide that the tax required from a PTE making the election “may not exceed the sum of all of the members’ shares of the PTE’s distributable cash flow.”⁹

Moreover, the new law “is revenue neutral for PTE’s paying tax on member’s share of taxable income,” because both the individual and corporate members receive corresponding credits for the taxes paid.¹⁰

If a PTE makes this election, the tax for such PTE will equal:

the sum of the lowest county tax rate [2.25%] imposed and the top marginal State tax rate [5.75%] for individuals applied to the sum of each individual member’s distributive or pro-rata share of the PTE’s taxable income.“⁷

A PTE’s election will also result in the PTE paying at a tax rate of 8.25% as to the corporate PTE member’s taxable income shares.8

Conclusion

Maryland’s new law has the potential to relieve PTE members of their individual state income tax burden. Again, PTEs can elect to pay the individual’s liability—and, significantly, PTEs are not subject to the federal $10,000 deduction cap. This new law is especially helpful in light of the COVID-19 because PTEs and their owners need all the relief they can get.

If you have questions or concerns regarding how you can take advantage of the SALT workaround, call Frost Law today at (410) 862-2890.

Footnotes

  1. Department of Legislative Services 2020 Session, Fiscal and Policy Note at: http://mgaleg.maryland.gov/2020RS/fnotes/bil_0003/sb0523.pdf.
  2. https://governor.maryland.gov/wp-content/uploads/2020/05/SEN-EWS-Letter.pdf.
  3. Department of Legislative Services 2020 Session, Fiscal and Policy Note at: http://mgaleg.maryland.gov/2020RS/fnotes/bil_0003/sb0523.pdf.
  4. https://www.districtofcolumbiataxattorney.com/Articles/Proposed-Regulations-Clarify-Tax-Treatment-of-Charitable-Donations-in-Return-for-SALT-Credits.shtml.
  5. IRC §164(b)(6), added by the Tax Cuts and Jobs Act of 2017, Pub. L. No. 115-97, §11042.
  6. Keshia Clukey and John Herzfeld, States Stand by SALT Deduction Workarounds, Bloomberg Tax: Daily Tax Report (Jun. 12, 2019).
  7. Department of Legislative Services 2020 Session, Fiscal and Policy Note paraphrasing Md. Code, Tax-Gen. §10-102.1(d).
  8. Md. Code, Tax-Gen. §10-102.1(d).
  9. Department of Legislative Services 2020 Session, Fiscal and Policy Note paraphrasing Md. Code, Tax-Gen. §10-102.1(d)(3).
  10. Department of Legislative Services 2020 Session, Fiscal and Policy Note. See new Md. Code, Tax-Gen. §10-102.1(e).
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