In 2020, Maryland enacted an optional tax on pass-through entities that allows them to, in effect, pay some state income taxes on behalf of their resident members. This law – along with a recent notice from the IRS — may give an important federal tax benefit to members of Maryland pass-through entities. There are, however, some important complications to know about, and taxpayers who want to benefit should act before the end of 2020.

Background

As you know, back at the very end of 2017, the Tax Cuts and Jobs Act was rushed into law, and one of its revenue-raising provisions was to limit the itemized deduction for income and property taxes to $10,000 per year. For higher-income taxpayers – particularly those living in states with higher state income tax rates – this change caused a substantial limit on their itemized deductions. Many of our clients pay property taxes in excess of $10,000 per year; consequently, they effectively get no deduction for their state income taxes. Between this limitation and the increase in the standard deduction, many taxpayers who had itemized their deductions for decades suddenly found themselves using the standard deduction.

States whose residents had suddenly lost the ability to deduct their state income taxes have tried various ways to help their residents get around this problem. For example, some states tried to have state income taxes recast as charitable contributions. The IRS has quashed most of these efforts.

A more recent attempt to accomplish the same goal, however, has met with success. Midway through 2020, Maryland passed a law that allowed pass-through entities (S corporations, partnerships, and LLCs) to elect to pay tax on the income allocable to resident owners. The owners will then get a credit on their Maryland individual returns for their share of taxes paid at the entity level. Last month, Treasury released a notice effectively giving its blessing to this treatment. The notice (Notice 2020-75) says that if a state imposes an entity level tax on a pass-through entity, subject to certain restrictions, the entity may take the tax as a deduction in calculating its ordinary income.

The effect of the new state laws and the IRS notice is that taxes that previously were “wasted” as a disallowed itemized deduction will now reduce ordinary income from a pass-through entity. Put another way, taxes that were non-deductible have now effectively become an above-the-line deduction. Notice 2020-75 applies to taxes paid to other states as well as MD. Certain taxes paid to DC will qualify for the same treatment, and other states have enacted similar measures.

There are a couple of intricacies that you need to be aware of. First, there may be some problems for pass-through entities that have both resident and non-resident owners. Second, there was a drafting error in the Maryland law that makes its efficacy questionable; however, it appears that there will be a retroactive technical amendment early next year to fix this problem. Additionally, the tax will only be deductible at the entity level in the year it’s paid, so pass-through entity owners who want to take advantage of the new law in 2020 have to make sure the entity pays the taxes before the end of the year.

The IRS notice tells us what Treasury intends to put in regulations, but the regulations themselves have not been issued. Because we don’t have final regulations and because we don’t have the Maryland technical corrections yet, we can’t say with certainty that all pass-through entity owners can benefit. What we can say:

1. Pass-through entities that have only Maryland resident owners can get a benefit. In some cases, this benefit will be quite large, and the entities should begin planning immediately so that they can make deductible payments by the end of the year.
2. Pass-through entities that have both resident and non-resident owners may get a similar benefit, but they may have to take additional steps to do so. Partnerships and LLCs may have to make changes to their operating agreements. S corporations with both resident and non-resident shareholders may not have certainty before the end of the year, but there may also be a work-around for some S corporations.

As is the case with all new tax developments, we haven’t included all of the details, and there are a number of them. Pass-through entities (and their owners) who might benefit from the new legislation should contact us so that we can help them get the largest tax benefit possible.

 

By Greg Yoder