Legislation enacted in Maryland on May 8, 2020 creates an election for pass-through entities (PTEs, e.g., partnerships, S corporations, limited liability companies (LLCs) that are not taxed as corporations in Maryland, etc.) to pay tax at the entity level rather than at the level of the members of the entity, which creates a corresponding tax credit for members. The law was enacted in response to the annual $10,000 cap on state tax deductions introduced under the federal Tax Cuts and Jobs Act enacted in December 2017. Maryland was one of several states searching for ways to help residents mitigate the impact of the SALT cap. The law applies as from July 1, 2020, and the election for PTEs applies to tax years beginning on or after January 1, 2020.
Significantly, on November 9, 2020, the IRS released Notice 2020-75 to announce that the IRS and Treasury intend to issue proposed regulations to clarify that state and local income taxes imposed on and paid by (which the IRS has coined “Specified Income Tax Payments”) a PTE on its income may be deducted by the PTE in computing its non-separately stated taxable income or loss for the taxable year of payment.
PTE Tax Election
For tax years beginning after December 31, 2019, Maryland now allows qualifying PTEs to elect to be taxed at the entity level with respect to the distributive shares or pro rata shares of income of resident members of the PTE. Qualifying PTEs include S corporations, partnerships, LLCs not taxed as corporations in Maryland, and business or statutory trusts not taxed as corporations in Maryland. As currently drafted, the law allows qualifying PTEs with resident individual and corporate members to make the election. The amount of the PTE tax cannot exceed the PTE’s total distributable cash flow for the tax year. The legislation also addresses application of the PTE tax election to tiered partnership structures. The Maryland PTE tax election does not apply to distributive or pro rata shares of income of tax-exempt entities under IRC Section 501 or real estate investment trusts (REITs) as defined by IRC Section 856.
Historically, Maryland has imposed an entity-level tax on PTEs with respect to the entity’s nonresident members based on the sum of each nonresident member’s distributive or pro rata shares of income. This mandatory PTE nonresident tax was characterized as a state tax paid by the PTE “on behalf of” its nonresident members. The new election expands this treatment to Maryland resident members, but characterizes the PTE tax not as a payment “on behalf of” resident members, but as a tax on the PTE.
Qualifying PTEs that make the election compute an aggregate amount of tax based on rates that depend on whether the PTE has resident corporate or individual members. If the PTE has corporate members, it calculates its PTE tax at the Maryland corporate income tax rate (8.25% for the 2020 tax year) on the members’ distributive or pro rata shares of income. For individual resident members, the electing PTE must pay tax on individuals’ distributive or pro rata shares of income at the highest marginal state income tax rate, plus the lowest county tax rate. The highest marginal state individual income tax rate for the 2020 tax year is 5.75% and the lowest county individual income tax rate is 2.25%, for a total of 8%.
Credits for Members of Electing PTEs
If the PTE tax election is made, both corporate and individual members of the PTE will receive a corresponding and refundable Maryland state income tax credit, as well as a Maryland county tax credit, based on their share of the Maryland PTE tax paid by the entity. A member must still include its distributive or pro rata share of PTE income in its Maryland individual or corporate income tax base and compute the respective Maryland income tax but may use the pass-through tax credit to offset the Maryland individual or corporate tax liability. If a member’s Maryland tax liability is less than the amount of the credit, the excess is refunded to the member.
Credit for Taxes Paid to Other Jurisdictions
Maryland’s legislation also allows all PTE members that are Maryland residents to take a credit for state income tax paid to other states, including by the PTE. However, this credit cannot exceed the member’s share of the pro rata tax paid by the PTE.
Making the Election, Forms and Reporting
In September 2020, the Maryland Comptroller’s office updated Administrative Release No. 6, to include guidance on how to make the PTE election. The election is formally made on Form 510. Estimated payment forms have been updated to include a box to note whether the payment is towards the PTE tax. Maryland Form 510 Schedule K-1 must reflect the PTE tax paid on the partner or shareholder’s share of income for the credit to be taken on the Maryland individual income tax return.
- Maryland is the most recent state to enact a PTE tax election, joining Louisiana, New Jersey, Oklahoma, Rhode Island and Wisconsin. Maryland’s election is more like the regimes enacted by New Jersey and Rhode Island, both of which provide a refundable tax credit at the member level. Conversely, Louisiana, Oklahoma and Wisconsin do not provide for a credit to the member, rather the members would reduce their state taxable income by their pro-rata share of income taxed at the entity level by the electing PTE.
- Pursuant to discussions with the Comptroller of Maryland’s office, it appears the state is considering some technical corrections, including clarifying that the tax applies to Maryland apportioned income and whether the PTE election may extend to the income on nonresidents, although these changes are not likely to be passed until 2021. However, according to IRS Notice 2020-75, the federal tax deduction applies to the tax year in which the payment is made, which is creating some practical issues for taxpayers trying to decide whether to make estimated payments before the end of 2020.