Maryland has become the most recent state to adopt a workaround to the federal $10,000 state and local tax (SALT) deduction limitation. On May 7, 2020, Senate Bill 523 became law, making Maryland one of a handful of other states, including Connecticut, New Jersey, and Wisconsin, attempting to circumvent the SALT limitation implemented by the Tax Cuts and Jobs Act (TCJA). The legislation amends Maryland’s pass-through entity tax (PET), which generally operates as a typical non-resident withholding regime, to create an election for the PET to apply to income of pass-through entity owners that are residents of Maryland. However, the election, which is effective for tax years beginning after December 31, 2019, includes multiple elements that make Maryland’s PET prone to a potential IRS attack.
In December 2017, TCJA limited the SALT deduction to $10,000, significantly decreasing the itemized deductions of many taxpayers. The initial response by several high-tax states was to create plans in which charitable giving to state-specified organizations would allow taxpayers a dollar-for-dollar credit against their state income tax liability. Ultimately, the Internal Revenue Service (IRS) deemed this workaround not acceptable, so states looked to other ways to side-step the SALT limitation. The adoption of a state level PET results in the imposition of the income tax at the entity level, instead of the standard flow-through treatment where individual owners pay the tax on their own returns. A PET allows the business entity to claim the state tax deduction on a federal income tax return, which is not subject to the TCJA $10,000 limitation placed on individuals.
Of course, just as the IRS deemed the charitable deduction schemes as impermissible, there are certain elements to state PETs that could lead to the same demise. In particular, Maryland’s new PET has a number of features that suggest it is merely a withholding tax in disguise, as opposed to a tax imposed on the business entity itself. These include the following:
- The expansion of the PET to income of residents is elective
- Different tax rates apply depending on the type of taxpayers that own the pass-through entity (i.e. individual or corporate)
- The PET does not apply to any portion of income attributable to a member that is also a pass-through entity
- Non-resident individuals and corporations that own a pass-through entity that makes the PET election still have a filing obligation, even if the owner has no other Maryland source income
- Individual and corporate owners of a pass-through entity that makes the PET election are required to claim a credit for the tax paid by the pass-through entity instead of an income back out
The General Assembly may have concluded some of these elements were somewhat unavoidable given that Maryland has both a state and local level income tax imposed on individuals. Ideally, a PET would be imposed at one rate, non-resident and corporate owners with no other Maryland source income would not be required to file a return, all income would be taxable at an entity level (including income flowing to another pass-through entity), and owners would get an income backout and not a credit for taxes paid by the pass-through.
Putting aside the IRS potentially targeting state PETs, pass-through entities with business activity in Maryland likely have no reason not to make the PET election. Given the recent enactment of SB 523, the Comptroller has not yet updated its forms or provided any guidance as to the method by which the PET election will be made. This information will likely be available in a few months.
If you have any questions on state pass-through entity taxes, please contact Michael L. Colavito or one of our tax advisors at 301.231.6200.