The Massachusetts legislature, overriding Governor Baker’s prior veto, has voted to enact a new elective pass-through entity (“PTE”) tax designed as a way for PTE owners to get out from under the $10,000 cap ($5,000 for married individuals filing separately) on federal income tax deductions for state and local income, sales, and property taxes (“SALT”). The SALT cap was imposed by the Tax Cuts and Jobs Act (“TCJA”) passed in 2017 and in effect through December 31, 2025 (absent future legislative action).[1] In this advisory, we outline considerations for entities treated for tax purposes as partnerships or S corporations.
The Workaround
How does paying additional taxes to Massachusetts result in a tax break at the federal level? The Internal Revenue Service (“IRS”) issued Notice 2020-75 in November 2020, in which it announced that it intends to issue proposed regulations to clarify that SALT taxes imposed on PTEs, at the entity level, are deductible in computing the PTE’s non-separately stated taxable income or loss. The Massachusetts PTE tax – like similar taxes enacted in other states in response to Notice 2020-75 – was designed to be deductible under Notice 2020-75. Although such regulations have yet to be issued, the Notice makes it clear that, in the meantime, taxpayers may rely on the guidance in the Notice.
The Mechanics of the New PTE Tax
S corporations, partnerships, or limited liability companies taxed as S corporations or partnerships (“eligible PTEs”) may elect, on an annual basis, to be subject to the Massachusetts PTE tax and, once made, the election is irrevocable for the relevant tax year. All stockholders, partners, or members, as applicable, of the electing PTE are bound by the election. The new PTE tax is effective for taxable years beginning on or after January 1, 2021, so eligible entities may make the election for its current taxable year.[2]
The PTE tax is imposed at a rate of 5% (the same rate as the Massachusetts personal income tax rate, subject to some exceptions) on a PTE’s “qualified income taxable in Massachusetts”, i.e., the PTE’s income determined under Chapter 62 of the Massachusetts General Laws that is allocable to a “qualified member” and included in such member’s Massachusetts taxable income under Chapter 62. The term “qualified member” generally includes a shareholder, partner, or member, as applicable, that is a natural person, trust, or estate. The tax is due and payable on the eligible PTE’s originally, timely-filed return. Importantly, each qualified member of an electing eligible PTE is allowed a refundable credit against the PTE tax equal to 90% of such member’s share of the tax. By not making the credit equal to 100% of a member’s share of the tax, Massachusetts will generate additional tax revenue, while also allowing PTE owners a net tax break due to the federal income tax deduction.
The election to be subject to the PTE tax becomes unavailable to eligible PTEs if and when the SALT cap expires or is otherwise not in effect.
What’s Next?
The new law directs the Massachusetts Commissioner of Revenue to promulgate regulations or other guidance to implement the PTE tax. The bill states that such guidance may “(i) make the credit available to qualified members with income from eligible pass-through entities that in turn have income from other eligible pass-through entities; (ii) provide rules on the application of this chapter to eligible trusts and estates; and (iii) require estimated payments of the excise by eligible pass-through entities and their qualified members in a manner consistent with chapter 62B.”
We are continuing to monitor updates and will keep you apprised on future developments.
[1] The SALT cap is codified in Section 164(b)(6) of the Internal Revenue Code.
[2] The PTE tax is codified in new Chapter 63D of the Massachusetts General Laws.
