Ever since the sweeping tax law changes brought about by the Tax Cuts & Jobs Act of 2017, high-tax states like Maryland have been scheming to circumvent the $10,000 cap on state tax deductions. After some trial and error, the U.S. Treasury and the IRS approved one of those schemes.
Maryland is now allowing pass-through entities (PTE) to elect to subject themselves to an entity-level tax on behalf of Maryland resident members. The members that had Maryland tax paid on the PTE level will receive a corresponding state tax credit for the same amount. The benefit of this is that a PTE can deduct the tax paid on the PTE level, which will then flow to the member’s K-1. This is effective for any tax payments made after November 9, 2020.
At this point in time there is not a lot of guidance, especially from the IRS. In Notice 2020-75, which approved this strategy, the IRS announced that they, along with Treasury, intend to issue proposed regulation to clarify this strategy. Below are some of the potential questions that hopefully will be addressed by the IRS.
The S-Corp Conundrum
In order to qualify as an S-Corp, the corporation can only have one class of stock. Essentially this means that all income, deduction and distributions need to be prorated equally based on ownership percentages. This new tax deduction only applies to Maryland resident shareholders and not to non-residents. Based on the S-Corp rules the tax deduction will be allocated to the non-resident as well.
On the flip side, the deduction is only a federal deduction and needs to be added back when calculating Maryland income, which again will be added to the non-resident Maryland income. Based on this there will need to be some creative workarounds in order to make sure that the shareholders are on equal footing.
Refunds
By making the election for 2020, Maryland will allow the PTE to pay the Maryland tax for the entire 2020 income. So potentially for the fourth quarter estimates, the PTE will be paying in the entire year of Maryland tax. However, the member would have already paid in the first three quarters of Maryland tax on the individual level. This will most likely result in the member receiving a Maryland refund when filing the individual return.
Additionally, what happens if you are a partner in two PTEs? One has a Maryland taxable income but the other has a corresponding loss so essentially there is no Maryland tax due on the individual Maryland return. My opinion is that the IRS will not allow you to get a deduction on the PTE level for taxes paid, that ultimately will be refunded on the individual level. Most likely the taxpayer will need to pick up income in the following year.
In the first scenario mentioned above, where you already paid a significant amount on the individual level, how will income be calculated? Is the last payment made considered what is being refunded or will it be allocated?
Trusts
It appears that you will be able to withhold for Maryland resident trusts as well. What happens at the trust level if all or part of the income is distributed to the beneficiaries? Do you follow the tax through to the beneficiaries or does it stop with the trust, in which case you would have to pick up all of the income the following year? What happens if some of the beneficiaries are non-resident — does that change anything?
Active vs. Passive
Will the IRS allow a deduction for all classes of income? Or will the deduction only apply to the income related to the active part of the business? Can a taxpayer setup a family LLC and put in all of their portfolio income (i.e. interest, dividend and capital gains) to pay the Maryland tax on the PTE level and get a deduction for it?
Schedule C and Schedule E
It appears that sole proprietorships and rental properties that are reported on the individual Schedule C and Schedule E will not be able to benefit from this deduction, which may prompt taxpayers to reconsider their entity choice.
What PTEs Should Do Now
No one knows exactly how the deduction will work and hopefully we will get more guidance before the end of 2020. In the meantime, PTEs should consider holding off on distributions as well as preparing tax projections so that when we do have more clarification, PTEs will be able to implement a strategy to get the most out of this deduction.
In some situations (as with a single Maryland resident shareholder) choosing to make the election may be simple. In more complicated situations your accountant may need to do a good bit of analysis before the end of the year.
For Help
Contact our tax department here or call 800.899.4623 to learn more about how your pass-through entity can minimize tax liability.
