Maryland Pass Through Entity Tax Election That May Result in Significant Tax Savings For Business Owners
On May 8, 2020, Senate Bill 523 was enacted into law, which created an election for Maryland pass through entities (“PTEs”) such as partnerships and S Corporations. This election gives PTEs the option to pay Maryland state income tax at the entity level instead of the tax being paid at the individual level by the pass through entity owners.
Maryland had been one of several states to search for ways to help its residents circumvent the Federal $10,000 State and Local Tax (SALT) deduction limitation that was part of the Tax Cuts and Jobs Act (TCJA) enacted in December 2017. As a result of this election, PTE Maryland resident owners could see significant federal tax savings on their tax returns. With payment possibly due by year end to take advantage of 2020 tax savings, it is critical that PTE Maryland resident owners reach out to their tax advisor as soon as possible.
Pass Through Entity 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
- Limited Liability Companies that are not taxed as a Corporation
- Business Trusts or Statutory Trusts that are not taxed as a Corporation
Qualifying PTEs with Maryland resident individual and corporate members are allowed to make the election. The amount of the PTE tax cannot exceed the PTE’s total distributable cash flow for the tax year.
Historically, Maryland has required PTEs to pay a pass through non-resident tax on its non-resident owners’ distributive or pro rata share of income. This tax, while paid at the entity level, was considered a tax assessed on the individual PTE owner and thus, made on behalf of the individual PTE owner. The taxes would be considered deductible for Federal income tax purposes as a SALT itemized deduction claimed on Schedule A of the PTE owner’s Federal individual income tax return.
However, a PTE owner may not have received a tax benefit for these taxes paid, as a result of the TCJA limiting the Federal SALT deduction to $10,000. This limitation resulted in taxpayers, who itemize, not being able to receive a tax benefit on their individual Federal income tax return for state and local income taxes, real estate taxes, and personal property taxes that were in aggregate in excess of the $10,000 limitation. The PTE nonresident owners were able claim the nonresident taxes paid as a tax payment on their individual Maryland non-resident income tax returns.
This new election expands the treatment to Maryland resident members, but characterizes the PTE tax not as a payment on behalf of its resident members, but instead as an entity level tax on the PTE. On November 9, 2020, the IRS issued Notice 2020-75 announcing its intention to issue proposed regulations to clarify that state and local income taxes imposed on and paid by a partnership or an S Corporation on its income are allowed as a deduction by the partnership or S Corporation in computing its non-separately stated taxable income or loss for the taxable year of payment. Note that the IRS indicates it will allow a deduction for the entity level tax in the year of payment, and thus would not allow accrual basis taxpayers to accrue the aforementioned tax deduction.
This IRS Notice effectively would allow a PTE Maryland resident owner to receive a tax benefit for entity level taxes paid by the PTE, despite the $10,000 Federal SALT deduction limitation, by having the tax payment deductible at the entity level in computing ordinary business income. This thereby reduces a PTE owner’s distributive or pro rata share of income reportable on the PTE owner’s individual income tax return. If applicable, this election would also reduce a PTE self-employed owner’s net earnings subject to self-employment tax.
Pass Through Entity Tax Rate
The new entity level tax, if elected, is calculated based on the aggregate amount of tax based on tax rates dependent on whether there are resident individual and/or corporate members.
If the electing PTE has corporate members, it calculates its PTE tax for these members at the Maryland corporate income tax rate on corporate members’ distributive or pro rata shares of income. The Maryland corporate income tax rate is 8.25% for the 2020 tax year.
The tax rate that an electing PTE pays tax on for its individual resident members’ distributive or pro rata shares of income is determined by the highest marginal individual state income tax rate plus the lowest individual county tax rate for that tax year. The highest marginal individual state income tax rate is 5.75% and the lowest individual county tax rate is 2.25% for a total of 8.00% for the 2020 tax year.
Pass Through Entity Tax Credit for Members
As a result of the election, both individual and corporate members would receive a corresponding and refundable Maryland state income tax credit based on their share of the entity level tax paid by the PTE. A PTE owner still includes their distributive or pro rata share of PTE income on their Maryland tax return, but may use the tax credit to offset their Maryland individual or corporate tax liability. A PTE owner will, however, be required to add-back the Maryland state taxes deductible at the Federal level when calculating Maryland taxable income. This add-back aligns with historically required treatment of entity level state taxes paid.
Credits for Taxes Paid to Other States and Localities
To avoid double taxation on the same income, Maryland allows taxpayers to claim credit for income taxes paid to other states and localities. Senate Bill 523 allows all PTE Maryland resident members to take a credit for state income tax paid to other states, including by the PTE. This credit cannot exceed the member’s share of the pro rata tax paid by the PTE. This can be beneficial as various states are allowing a similar pass through entity tax mechanism to help their residents overcome the Federal $10,000 SALT deduction limitation.
Summary of Impact of Pass Through Entity Tax Election
In summary, for Federal income tax purposes, the election results in the following:
- The electing PTE reports the Maryland state tax payment as a deductible state tax payment on its Federal tax return in computing its non-separately stated ordinary business income.
- The PTE owner receives a tax benefit for the entity level taxes paid by reporting the now reduced distributive or pro rata share of PTE ordinary business income on their individual Federal income tax return. This overcomes the $10,000 SALT itemized deduction for Federal tax purposes for payments that were previously paid at the individual level.
In summary, for Maryland income tax purposes, the election results in the following:
- The electing PTE pays the Maryland entity level tax computed based on a PTE’s resident owners in addition to the mandatory nonresident tax payment based on a PTE’s nonresident owners.
- A PTE owner will be required to add-back the Maryland state taxes deductible at the Federal level when calculating Maryland taxable income. A PTE owner’s add-back should be reported on their K-1.
- A PTE resident owner will receive a credit, for their share of Maryland taxes paid at the entity level, to be claimed on their individual Maryland tax return.
- If a PTE resident owner’s Maryland tax liability is less than the amount of the credit, then the excess is treated as a tax refund to the owner.
- A PTE resident owner may not need to pay estimated taxes at the individual level by virtue of the taxes being paid at the entity level.
Potential Tax Savings Example
Consider the following example that illustrates the potential tax savings a Maryland resident PTE owner may receive when making the election for a business to pay tax at the entity level.
- Taxpayer is a Maryland resident that holds 100% stock ownership in a S Corporation.
- The employee shareholder taxpayer earns $200,0000 in taxable W-2 wages from the S Corporation as reasonable compensation for services rendered to the corporation.
- The S Corporation reports $600,000 non-separately stated ordinary business income that flows through to the Taxpayer’s individual income tax return.
- The S Corporation is a Specified Service Trade or Business for Section 199A purposes.
- Taxpayer files a Married Filing Joint return that only includes the taxable income from the W-2 and S Corporation K-1.
- Taxpayer elects to take the itemized deduction by reporting deductible mortgage interest of $30,000 and the maximum SALT deduction of $10,000 when taking into account real estate taxes and Maryland income taxes.
If choosing to not make the election, then based on the assumptions listed above, the taxpayer will report Taxable Income of $760,000 ($800,000 Adjusted Gross Income less $40,000 Itemized Deduction) and be subject to regular Federal income tax liability in the amount of $218,349 with respect to the 2020 tax year.
Please note that in this example, the taxpayer would personally pay their full Maryland tax liability but would not see any tax benefit for the payments by virtue of the Federal $10,000 SALT deduction limitation.
However, if the Taxpayer decides to make the election and have the S Corporation pay the $48,000 ($600,000 x 8%) entity level tax in 2020, then the S Corporation is able to include the $48,000 as a deductible entity level tax payment on its 2020 tax return. This results in non-separately stated ordinary business income being reduced from $600,000 to $552,000.
The Taxpayer will now report Taxable Income of $712,000 ($752,000 Adjusted Gross Income less $40,000 Itemized Deduction) and be subject to regular Federal income tax liability in the amount of $200,589 with respect to the 2020 tax year. Please note that in this example, the Taxpayer receives a credit for the entity level taxes paid that is claimed on the Taxpayer’s individual Maryland tax return.
In the example above, the Taxpayer experiences $17,760 ($218,349 less $200,589) in tax savings by making the PTE election.
Administrative guidance still needs to be issued from the State of Maryland concerning the election. There is still much uncertainty including how to make the PTE tax election and how and when the PTE is to make the tax payment. Maryland will need to issue clarity regarding the potential entity level election treatment with regards to nonresident owners’ distributive or pro rata share of PTE income. Also, clarification is needed regarding how this may affect Maryland’s credit mechanism for taxes paid to other states and localities.
For planning purposes, Maryland PTE owners will need to consider the election and potentially alter their Maryland tax payments. Finally, the electing PTE may need to consider the accounting for this tax liability in their financial statements moving forward.
If you found this article helpful or would like to know more about what was discussed above, please reach out to a member of our SALT team for further assistance.
About Eric Ingis
CPA & Manager
With the firm since 2014, Eric has become an integral part of the firm’s tax team. Eric focuses on providing various tax advisory services for high net worth individuals, corporations and partnerships as well as providing state and local tax (SALT) advisory services to businesses of all sizes in order to mitigate risk, identify tax savings opportunities and remain in compliance with various state and local laws.
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