As a result of the federal 2017 Tax Cuts and Jobs Act, the maximum amount that may be deducted by individual taxpayers who itemize deductions for state and local taxes is limited to $10,000. In response to this limitation, Maryland Senate Bill 523 (the Bill) allows a pass-through entity, such as an S Corp or an LLC that is taxed as a partnership, to elect to be taxed at the entity level with respect to the state income taxes of the entity’s members.
The purpose of the Bill is to shift the deduction for state income taxes from the individual income tax return, where it is limited, to the pass-through entity tax return, where it should not be limited.
For example, assume a medical practice that operates as a limited liability company, which is taxed as a partnership, has a net income of $1 million, with two doctors owning a 50% interest in the practice. Without the Bill, each doctor would receive a Schedule K-1 showing $500,000 of income that would pass through to the doctors’ individual tax returns.
Assuming each doctor’s state income tax liability on such income were $40,000, and the real estate taxes on each doctor’s residence were $8,000, each doctor would be limited to an itemized deduction of $10,000 for state income and real estate taxes, even though the total state income and real estate taxes were $48,000.
But, if the medical practice were to make the election under the Bill and pay the doctors’ state income taxes, the medical practice would receive a deduction on its partnership income tax return in the amount of $80,000. Thus, the practice would report net income of $920,000, instead of $1 million, and each doctor would receive a Schedule K-1 showing $460,000, instead of $500,000.
Accordingly, by making the election under the Bill, the doctors are effectively able to fully deduct their state income taxes, because the amount of income reported on their Schedule K-1 is reduced by the amount of the state income taxes. The federal income tax savings for each doctor by making the election under the Bill in this example is approximately $12,000.
Although the Bill became effective July 1, 2020, and is applicable to the taxable years of pass-through entities beginning after December 31, 2019, the Maryland Comptroller’s Office has not issued any guidance on the new legislation and, therefore, the new law has many unanswered questions. For example:
In addition to the uncertainty regarding the mechanics of the election as described above, it is uncertain whether the Internal Revenue Service (IRS) will respect a deduction on a pass-through entity’s tax return for the state income taxes of its members.
Other states have enacted legislation similar to the Bill to address the $10,000 limitation on the deduction of state and local taxes, but neither the IRS nor the U.S. Department of the Treasury has issued any formal guidance as to whether such state legislation will be respected for federal income tax purposes.
The risks of the IRS not respecting the election include taxpayers having to pay interest and penalties on non-reported income.
A version of this article titled, “Understanding Md.'s pass-through tax election" was published in The Daily Record on March 17, 2021.
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