On Feb. 16, 2021, Maryland Gov. Larry Hogan signed Senate Bill 496 to amend the Maryland pass-through entity tax election to apply to all members (resident and non-residents) as the law previously applied to only resident members. Additionally, the amended law clarifies that the tax is imposed on the pass-through entity itself, and to the extent the members are subject to Maryland income tax they are entitled to a credit for their share of the pass-through entity tax. Finally, the amendments are retroactively effective for tax years beginning on or after Dec. 31, 2019 so taxpayers can make this election on their 2020 Maryland tax returns.
Background and the election
Recall that in 2020, Maryland first adopted a pass-through entity state and local tax deduction limitation workaround joining, at that time, six other states. Before the elective tax, the state imposed a nonresident member tax on pass-through entities at the entity level. While the tax was imposed on the entity, it was treated as a tax imposed on the nonresident or nonresident entity members paid on behalf of the nonresident members by the pass-through entity. The pass-through entity workaround amended the tax by providing that a pass-through entity may pay the distributive share or pro rata share of the nonresident and nonresident entity member of the pass-through entity (essentially the status quo), or, as amended, the entity may elect to pay the tax with respect to the distributive shares or pro rata shares of the resident members of the pass-through entity. Senate Bill 496 extends the elective tax to nonresidents.
If an entity elects to pay the tax on the distributive or pro rata shares of the members, then the partners, members or shareholders of the pass-through entity are eligible to claim a Maryland income tax credit based on their share of the entity’s taxable income. The tax rate is the highest state rate plus the lowest county income tax rate for individual members. For corporate members, the rate is the current corporate rate. The entity’s income is reported on the member’s return and the member will claim the credit for the part of the entity’s state plus local tax that relates to the member’s share of the entity income. For purposes of the election, pass-through entities include S corporations, partnerships, limited liability companies and business trusts or other entities not taxed as corporations.
Finally, Maryland requires quarterly estimated tax payments for the pass-through entity tax. For tax year 2021, taxpayers should consider the election before the first quarterly estimated tax payment is due, otherwise taxpayers risk being subject to underpayment penalties. Furthermore, since the original law was enacted in May of 2020 and applies to tax years beginning after Dec. 31, 2019, taxpayers who make the election for tax year 2020, but failed to remit the appropriate quarterly estimated tax payments, may also receive underpayment penalties.
The Maryland Attorney General noted some concerns with the treatment of nonresident members in the adopted statutory language when the workaround was enacted in 2020. Senate Bill 496 appears to resolve those concerns.
The Maryland pass-through entity tax is intended to provide a workaround to the federal $10,000 limitation on the state and local tax deduction. The federal deduction for the new state tax would be claimed at the entity level, but the members would receive a state credit. Importantly, taxpayers should analyze whether making the election and paying the entity-level tax will result in a lower overall tax burden. Maryland pass-through entities considering electing into the new tax are cautioned that not all owners may benefit from such an election. As in the seven other states that have adopted the workaround tax, making the election may, or may not, create significant tax savings when aggregating federal and state tax liabilities.
Taxpayers are encouraged to contact their state and local advisers to determine if electing into an entity-level tax is a favorable and ultimately tax-saving strategy.