As 2020 passed the halfway mark, a new law took effect in Maryland that allows owners of pass-through entities (PTEs)—such as S-Corporations, partnerships, and LLCs—to potentially avoid the $10,000 itemized deduction limitation on state and local taxes. With this change, Maryland joins several other states with similar legislation in place.
Under the Tax Cut and Jobs Act of 2017 (TCJA), the limit on itemized deductions for an individual’s state and local taxes of individuals was $10,000. However, this statute only affects individual taxpayers’ tax returns, not business tax returns. Under Maryland Senate Bill 523, PTEs—rather than their owners—can elect to be subject to Maryland state income tax. Since this tax then becomes the obligation of the PTE, it will lower the net federal income passed through to the owners. Although the PTE income is still reportable on the owners’ Maryland income tax returns, they will receive a Maryland tax credit that should offset all or most of the tax on this income. The net effect is to reduce the owners’ taxable federal income—thus avoiding the $10,000 limitation—while not impacting Maryland tax revenues.
While the law took effect on July 1, 2020, it will retroactively apply to tax years that begin on or after January 1, 2020. This new entity level tax will be applied at the top Maryland individual tax rate, plus the lowest county tax rate, or the corporate tax rate for corporate owners of the PTE.
Several questions still remain unanswered until regulations are issued, such as 1) How and when to make the election; 2) Is this an annual election or does it need to be made each year; and 3) What happens if the PTE is sold?
In late 2019, the IRS blocked several states’ individual attempts to circumvent the $10,000 cap, but so far have not challenged this move by Maryland state lawmakers.
What if you own a sole proprietorship or other business filing a Schedule C, E of F? While this new law may not apply in those circumstances, there are strategies you can implement—such as incorporating the business of forming an eligible partnership or LLC—to capitalize on its tax deduction framework.
Individuals who have questions regarding the information noted above should contact their E. Cohen advisor before taking any action, as this legislation may still be subject to future IRS challenges.