On May 7, 2020, Maryland Governor Larry Hogan allowed Senate Bill 523 to become law. This Bill considerably changes the state tax landscape for Maryland entities (LLCs, Partnerships and S Corps primarily) and the individuals that pay tax on that income. It goes into effect for tax years beginning after December 31, 2019.
Why was this Enacted?
The Tax Cut and Jobs Act of 2017 severely limited the amount of State and Local Tax (SALT) that an individual could deduct. Prior to the law, taxpayers deducted all state and local taxes paid AND real estate taxes paid via Schedule A-Itemized Deductions. Since the law’s implementation, taxpayers are limited to deducting a MAXIMUM of $10,000 in SALT payments. The remaining SALT payments are simply disallowed.
Senate Bill 523 shifts the state tax burden from the taxpayer (typically an individual taxpayer) to the PTE. In doing so, the tax paid by the PTE becomes federally tax deductible to the PTE thus effectively allowing the taxpayer to realize the benefit of the deduction for those tax payments.
How Will It Work?
Basically the Pass Through Entity (PTE) must ELECT to impose the tax on the entity. The tax will be calculated using the highest individual rate PLUS the lowest county individual rate (will use the corporate rate if the entity member is a corporation). The taxpayer will still include the PTE income on their return but get a Maryland credit for the taxes paid by the PTE. The PTE will take a federal income tax deduction for the MD PTE tax paid. Thus, the taxpayer will effectively receive a deduction for the SALT taxes by virtue of the PTE income being reduced by the taxes paid.
While this all sounds like a smart idea, there is some exposure. Maryland is one of a half-dozen or so states to adopt a similar strategy as a workaround. I have to think that the IRS will look at these and scrutinize the plan. There is nothing wrong with the taxing structure at all. Some states have long had entity level taxes that work quite similar to this MD structure. But given that the scheme was implemented as a direct response to the SALT limitation, I do expect some push-back from the Feds.
When Should I Not Elect?
The decision to make this election will need to be done on a case-by-case basis. Many PTEs and their owners will see a considerable overall tax reduction via this election. But there will undoubtedly be scenarios where the election doesn’t make sense.
While I can’t make a uniform recommendation to make the election, it’s clear this should be discussed with every PTE filer and the members. Please reach out to our office to discuss this election and it’s implications to your tax situation.