In late 2020, the IRS issued a notice confirming imminent proposed regulations that would allow certain tax strategies to avoid the individual $10,000 state and local tax (“SALT”) deduction limitation of the Tax Cuts and Jobs Act (“TCJA”, P.L. 115-97 (Dec. 22, 2017)). (Notice 2020-75). This notice cited a 1958 revenue ruling that allowed a partnership to subtract a local tax in calculating its net income to its partners, thereby holding that partners who use the standard deduction without itemizing their deductions may still receive the tax benefits from having the local tax “subtracted” at the partnership level from the calculation of their net income from the entity. Thus, effectively, this notice provided federal support to states for enacting SALT deduction workaround legislation that reduces the impact that the TCJA’s SALT limitation inflicts on individual taxpayers.
Even prior to the notice, numerous states had enacted “workarounds” to the SALT deduction limitation. The SALT deduction workarounds, which either require a Pass-Through Entity (“PTE”) to pay a tax at the entity level, or allow a PTE to elect to pay the tax at the entity level. The workarounds then provide either: (1) an adjustment to the PTE owner’s income, thereby removing the owners pro rata share of the income taxed at the entity level; or (2) allowing a credit against the PTE owner’s income tax for the owner’s pro rata share of the tax paid by the PTE. Virginia, like many other states, has not enacted a SALT deduction limitation workaround nor has it commented on the treatment of PTE level taxes paid to other states. That was until its response to a request for a ruling was issued on December 28, 2021. This request was prompted by Maryland’s enactment of workaround legislation that allows a PTE to elect to pay tax at the entity level and provides for a tax credit on the PTE owner’s return. The issue addressed in the ruling is whether a PTE owner who is a resident of Virginia is allowed to claim a credit for the owner’s pro rata share of the tax paid by the PTE to Maryland. Each state’s treatment of the SALT deduction limitation workarounds is further detailed in this alert below.
TCJA’s SALT Deduction Limitation and PTE Taxes Generally
Currently, federal law limits individual taxpayer’s itemized deduction for SALT related payments to $10,000 annually, or $5,000 annually for married taxpayers filing separately. Previously, taxpayers were allowed to fully deduct state and local tax payments for purposes of either income or sales taxes and property taxes. Following the enactment of the TCJA, these amounts were capped for individual taxpayers unless such payments were made in pursuit of a trade or business.
To assuage the effect of this limitation, many states responded by enacting either an elective or mandatory PTE level Tax that essentially re-characterized individual state income tax expenses that were no longer deductible into business expenses deductible for federal income tax purposes. The elective PTE taxes work in the following manner: 1) the PTE voluntarily elects to pay tax at the entity level; 2) the PTE owners report their allocable or pro rata share of PTE income on their individual state tax returns, and are then allowed a full or partial credit against their individual tax liability for their allocable or pro rata share of the PTE tax paid by the entity.[1] Treatment of excess credits varies depending on the state, with some allowing a refund and others only permitting a carryforward. Because the tax paid by the PTE is a deductible business expense, it reduces the PTE’s taxable income, and thereby, reduces the PTE owner’s allocable or pro rata share of the PTE’s income. For federal income tax purposes, the PTE level tax reduces the owner’s federal income tax liability.
Maryland PTE SALT Cap Workaround
Maryland originally enacted PTE legislation applicable to tax years beginning in 2020. [SB 523. Chpt 641, Laws of 2020.] The Comptroller of Maryland issued guidance with respect to the State workaround when it revised its Administrative Release 6 (Taxation of Pass-Through Entities) in September 2020. Retroactive “corrective” amendments were made to the Maryland workaround statutes during the 2021 Legislative session. [SB 496, Chpt. 39, Laws of 2021.]
The Law allows an electing PTE to pay an entity level income tax on its Maryland taxable income.
PTEs eligible for the election include S corporations, partnerships, limited liability companies (not taxed as a C corporation), and business or statutory trusts (not taxed as a C corporation). (Md. Code. Ann., Tax-Gen. § 10-102(a)).
The owners of the PTE will still include their distributable or pro rata share of the PTE income when calculating their Maryland state and local taxes. The owners are allowed to claim a credit against their Maryland tax for their allocable or pro rata share of the Maryland income tax paid by the PTE. Additionally, the PTE’s owners are allowed to claim a credit for the owner’s allocable or pro rata share of entity level income taxes a PTE pays to another state.
It should be noted that the differential for resident individual owner that have higher local tax rates will not impact the taxes actually paid by the PTE. The differential is paid by the individual owner on his or her Maryland tax return.
The Comptroller published a list of Frequently Asked Questions on September 10, 2021. FAQ 15 asks, “Can an individual resident member of an electing PTE claim a credit for entity level taxes paid to another state by a PTE?” Initially, the response to this question was “No,” which seemed to contradict the amended statute specifically. (See Md. Code. Ann., Tax-Gen. § 10-703). Following comments from concerned practitioners, on December 27, 2021 the Comptroller revised the response to FAQ 15 to provide that a resident is allowed a credit against the resident’s Maryland income tax for income taxes paid by a PTE to another state.
Virginia PTE SALT Cap Workaround
Practitioners recognized that Maryland’s legislative enactment brought about the obvious question as to whether Virginia would allow its residents to claim a credit against their Virginia individual income tax, which will include tax on their pro rata or distributable share of PTE income included in their Virginia taxable income, for the tax paid by the PTE to Maryland. Accordingly, a request for a ruling on the PTE SALT cap workaround and eligibility for a credit against the Virginia tax for PTE tax paid to Maryland was submitted to the Virginia Department of Taxation. In the request, it was asserted that Virginia should allow the credit because a Virginia resident taxpayer is subject to Maryland income tax on Maryland source income, regardless if the election is made or not, and the PTE tax functions in such a manner where the effect remains the same though it is re-characterized solely for federal income tax purposes.
On December 28, 2021, the Virginia Tax Commissioner responded to the inquiry, solidifying the Commonwealth’s position on the issue. The ruling reaffirms that Virginia law allows residents a credit on their Virginia individual income tax return for income taxes an individual paid to another state, while disallowing a credit for other taxes (such as franchise, excise, unincorporated business taxes, etc. (Va. Code Ann. § 58.1-332 A). Thus, in turn residents may claim a credit for other state income taxes on their distributive share of PTE income sourced to such state. Additionally, tax that is paid by an electing S corporation is deemed as having been paid by its shareholders in proportion to their ownership of the S corporation. (Va. Code Ann. § 58.1-332 C).
Citing this same statute, the ruling emphasizes that similar credits are not available for other PTEs. Instead, Virginia law expressly disallows a credit from being claimed by an individual for other state taxes imposed on a distributing entity in which the individual is a beneficiary or shareholder, unless such distributing entity is an S corporation. (23 Va. Admin Code § 10-110-221). The ruling cites to Howell's Motor Freight, Inc., et al. v. Virginia Department of Taxation, which upheld the Department’s denial of a credit to Virginia residents on the basis that the corresponding statute must be construed as written. (Circuit Court of the City of Roanoke, Law No. 82-0846 (Oct. 27, 1983).
The ruling acknowledges that the Maryland PTE SAT workaround provides a tax on income that allows the availability of a Virginia credit for taxes paid to another state. However, because of current Virginia law, entity level taxes are not attributable to the individual members, unless such members are shareholders of an S corporation. Thus, Virginia residents who are shareholders of S corporations that elect to be taxed at the entity level for purposes of Maryland’s PTE tax are eligible for the credit for taxes paid to Maryland by the PTE. However, for Virginia residents with ownership interest in other types of PTEs that make the election for the benefits presented by Maryland’s PTE workaround, such residents shall not be entitled to the credit.
District of Columbia PTE SALT Cap Workaround
The District of Columbia has perhaps taken the most silent approach out of the tri-jurisdiction area. At the present time, the Office of Tax and Revenue (“OTR”) does not plan to issue any published guidance on the question of whether DC will allow its residents a credit against their DC tax for taxes paid by a PTE to another state. In support of this position, it cites to the language of its statute that requires a review and analysis of each state’s law to determine if a credit will be allowable. OTR is advising taxpayers that they may apply for a private letter ruling on the payment of tax to a specific state. The private letter rulings will not be made available to the public in a redacted form because of ongoing litigation regarding the question as to whether DC is required to produce redacted versions of rulings under a FOIA request.
Commentary
Given the varying rules in each jurisdiction, owners of PTEs filing in multiple states should analyze the laws in each applicable state, including their resident state, prior to making an election to have the tax paid at the entity level. There is the risk that, similar to Virginia, a state will not allow a credit for entity level taxes paid by the entity to another state.
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[1] Some states provide a modification in the form of a subtraction or adjustment from federal adjusted gross income to remove the income for which state tax has been paid by the PTE. In this instance, no tax credits are allowed for the PTE level paid tax.
Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. The author has provided the links referenced above for information purposes only and by doing so, does not adopt or incorporate the contents. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.
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