What is a Pass-through Entity Tax?
The Tax Cuts and Jobs Act of 2017 (TCJA) imposed a $10,000 limitation on the state and local tax (SALT) deduction for individuals who itemize deductions on their federal income tax return for tax years beginning after 2017 and before 2026. In response, many states have enacted a mandatory or elective pass-through entity (PTE) tax as a workaround to the SALT cap.
The PTE tax allows eligible pass-through entities to deduct state taxes at the entity level for federal tax purposes, while providing a credit, deduction, or income exclusion to the passthrough entity owners for state income tax purposes. In November 2020, the Internal Revenue Service (IRS) issued notice 2020-75, confirming that state taxes paid through a PTE are exempt from the SALT cap of $10,000.
As of July 10, 2023, there were 36 states (including Maryland and Virginia) and 1 locality that enacted a PTE tax, effective for 2022 year (or earlier). The District of Columbia, which has an owner-level personal income tax on PTE income, has not yet proposed or enacted PTE taxes.
District of Columbia
- D.C. has not yet proposed or enacted a PTE tax.
- D.C. allows the resident individual to claim a credit against such resident’s D.C. income tax liability for the PTE tax paid on such resident’s behalf to other state in the same manner as if these taxes were paid by the individual directly. D.C. residents may not claim the credit for a franchise tax, excise tax, unincorporated business tax, or any tax so characterized by the other taxing jurisdiction.
Maryland
- A qualifying PTE (partnerships, S corporations and LLCs) may elect to pay tax at the entity level rather than at the level of the members of the entity.
- The tax rate is 8% on the Maryland taxable income for its members who are individuals and 8.25% for its corporate members.
- Applicable to tax years 2020 and later.
- The electing PTE must file Form 511 (Pass-through Entity Election Income Tax Return).
- Two credits for the resident PTE members:
- Credit for their distributive share of the PTE tax paid by the entity. If the member’s Maryland tax liability is less than the amount of the credit, the excess is refunded to the member.
- Credit for state income tax paid to other states, including by the PTE. However, this credit cannot exceed the member’s share of the pro rata tax paid by the PTE.
Virginia
- A qualifying PTE is owned entirely by natural individuals and trusts qualified to be a shareholder in an S corporation.
- Tax rate is 5.75% at the entity level.
- An owner may claim a refundable PTET credit against their individual or trust income tax.
- Applicable to tax years beginning on or after Jan. 1, 2021, but before Jan. 1, 2026.
- For tax years beginning on or after Jan. 1, 2022, but before Jan. 1, 2026, the PTET election must be made by a qualifying PTE on its timely filed return, including any extensions. If elected, all owners are required to participate.
- VA legislation now allows taxpayers to claim a credit on their individual income tax return for certain taxes paid by a PTE under another state’s substantially similar PTE tax structure for taxable years 2021 through 2025 (unlike the new elective PTE tax that is delayed for the tax year 2021). This new provision of the legislation overrules prior legislation which generally denied a credit for a tax paid to Maryland under the state’s elective pass-through entity tax. It does not apply to other entity taxes, such us any non-elective franchise, privilege, business, license, occupation, excise, or unincorporated business taxes.
- Draft guidelines were released on October 31, 2022. Taxpayers who have already filed their 2021 Virginia individual tax return but need to make an adjustment should consult the instructions on the VA Department’s website for information on how to make the retroactive election for 2021.
