A recent amendment to Maryland’s pass-through entities bill has made changes to the state’s workaround statute to the $10,000 limit on federal deductibility of state and local taxes (SALT) imposed by the Tax Cuts and Jobs Act of 2017 (TCJA). The initial deduction limit has had a significant impact on taxpayers across the country, especially in states with a high-state income tax. As a result, states with a high-state income tax have enacted legislation that has attempted to “workaround” the SALT deduction limitation. Early on, some states provided individuals with a tax credit if they made a charitable contribution to a state fund. However, this workaround was eventually defeated by the Internal Revenue Service (IRS) when it adopted regulations which disallowed a charitable deduction, except for a limited de minimis exception. More recently, several states have enacted legislation that allows a partnership or S corporation (collectively referred to as "pass-through entities”) to pay a pass-through entity state income tax. This pass-through entity tax is then deductible in calculating the entity’s Federal taxable income, which is eventually allocated to its partners (in the case of a partnership) or its shareholders (in the case of an S corporation). The IRS, through Notice 2020-75, has approved of these types of statutes being passed by the states.
The approval by the IRS has offered various planning opportunities for pass-through entities in states where such legislation has been enacted. The Maryland legislature originally passed a pass-through entity bill that became effective July 1, 2020, but this was later updated by the Maryland Comptroller through Administrative Release No. 6 in September of 2020.1 At that time, the Maryland pass-through entity bill allowed for Maryland source business income to be taxed at the pass-through entity level rather than the individual, owner level. This is accomplished by having the pass-through entity elect to pay Maryland income tax at the entity level for any of its Maryland resident partners or shareholders. The pass-through entity then allocates the economic burden of paying such income tax to the Maryland resident, who will then be allowed to take a credit on his or her individual Maryland tax return. Thus, the pass-through entity bill is really an economic burden shifting scheme, which allows the tax burden to be shifted to the entity and passed out to the Maryland residents as a tax credit. The pass-through entity bill, however, did not provide nonresidents the same benefits as Maryland residents, but that changed with the most recent amendment (see below).
February 2021 Amendment
On February 15, 2021, the Maryland legislature, through SB 496, an emergency COVID-19 relief bill that Governor Hogan signed, further amended the pass-through entities bill. As amended, the statute now provides that if a pass-through entity elects to pay the entity-level tax, it must apply the tax to the distributive shares of all members. The tax incorporates two rates: a rate of 8% that applies to the distributive shares of individual members and a rate of 8.25% that applies to entity members.
As originally enacted, the statute allowed a pass-through entity to elect to pay a tax that applied only against the distributive shares of resident members. Under the original statute, a resident member of a pass-through entity appeared to include a Maryland corporation taxed as a C corporation that owned an interest in a pass-through entity. Therefore, prior to the most recent amendment, it seemed that a pass-through entity that elected to pay the tax would apply the tax to the distributive shares of its resident individual and C corporation members. In contrast, in a case in which another pass-through entity owned a membership interest Md. Code Ann. Tax-Gen. §10-102.1(f)(1)(ii) originally provided that the upper tier pass-through entity was to apply the statute, rather than the lower tier pass-through entity. One effect of the amendment is that a pass-through entity that elects to pay the tax now applies the tax to the distributive shares of all members, including the distributive share of an upper tier pass-through entity. Thus, the new amendment has clarified some prior uncertainties present in the original statute.
Additionally, the amendment expands the tax so that it now applies to the distributive shares of nonresident individual members, as well as resident and nonresident entity members. If a pass-through entity is owned entirely by Maryland resident individuals, the February 2021 amendment will have little to no impact.
Another major change in the statute is the way Maryland will calculate the adjusted gross income (AGI) of resident members of pass-through entities. Specifically, the amount of a member’s Maryland credit for the member’s share of the workaround tax paid by a pass-through entity is to be added to the federal AGI of a Maryland resident member to be used to determine Maryland AGI for such member.
Finally, the February amendment provides that all amendments have a retroactive effective date that applies to tax years beginning after December 31, 2019.
Planning Opportunities and Considerations
There are several planning opportunities as well as actions members of pass-through entities organized as partnerships or limited liability companies (LLCs) should consider. First, it should be noted that the Maryland SALT workaround statute does not apply to W-2 wage earners, self-employed individuals, businesses being operated as single-member LLCs that are treated as disregarded entities and sole proprietorships. Under the statute, a “pass-through entity” is defined as (1) an S corporation, (2) a partnership (includes limited partnerships and limited liability partnerships), (3) a limited liability company that is not taxed as a corporation, or (4) a business trust or statutory trust not taxed as a corporation.
Additionally, members of partnerships and LLCs should consider amendments to their internal organizational documents (e.g., partnership or operating agreement). As provided under Section 761(c) of the Internal Revenue Code, any amendments to partnership agreements would need to be made by March 15. As mentioned above, the most recent amendments call for a tax rate of 8% for individual members and 8.25% for entity members. It appears that in the case of a partnership or LLC with both individual and entity members, it will continue to be appropriate to make special allocations of the federal deduction. Specifically, the portion of the tax calculated at the 8% rate should be specially allocated to the individual members, and the portion of the tax calculated at the 8.25% rate should be specially allocated to the entity members. In addition, the members should consider whether adjustments to their distribution rights are necessary in order to prevent the specially allocated deduction and the corresponding Maryland credit from altering their underlying economic arrangement.
Buchanan’s tax and business planning attorneys are available to assist you and your pass-through entities with any tax needs as we all navigate changing tax laws at the federal and state levels.
- Md. Code Ann. Tax-Gen. §10-102.1(b)(2)(ii), as amended by 2020 Md. S.B. 523, effective for taxable years beginning after December 31, 2019; MD. Code Ann. Tax-Gen. §10-104(5); Maryland Administrative Release No. 6