August 17, 2021
Craig M. Burns
Virginia Department of Taxation
P.O. Box 546
Richmond, VA 23218-0546
Via email: [email protected]
RE: SALT Cap Workaround and related Credits against tax paid to other states
Dear Commissioner Burns:
The Virginia Society of Certified Public Accountants (VSCPA) Tax Advisory Committee is requesting a ruling request related to credit for state income taxes paid to another state by Virginia residents who are owners in pass-through entities (PTEs) which make an election to be taxed at the entity level. Our discussion below relates to recent legislation enacted by the state of Maryland.
As you know, the Tax Cuts and Jobs Act (TCJA) imposed limitations on individual taxpayers’ ability to deduct state and local taxes to $10,000, known as the “SALT Cap”. The SALT Cap particularly affects owners of small businesses who file pass-thru entity returns and pay tax at the individual owner level. The result is the business owners do not receive benefit of a federal tax deduction for most, if not all, income taxes paid in connection with their business activities. This creates a significant discrepancy with businesses that file corporate income tax returns as there is no similar limitation on state and local tax deductions for a corporate taxpayer.
In response to this limitation, several states have implemented an election for certain pass-through entities to be taxed at the entity level. If the election is made, the tax will act much like corporate income taxes where the tax will be assessed against the entity and therefore be deductible on the entity’s federal income tax return as a state and local income tax under IRC section 164. Such treatment was affirmed by the IRS in Notice 2020-75. The way the election is designed, the benefit will be to reduce federal taxable income. For state income tax purposes, the states have structured the elections such that the state will generally receive the same amount of state income taxes from the PTE and its owners that it would have received with or without the election.
Maryland recently passed legislation1 that allows PTEs (i.e. S Corporations, partnerships) to elect to pay Maryland taxes on behalf of all members, regardless of where the owners reside. Due to the proximity with Maryland, many Virginia residents are owners in small businesses which have nexus and file Maryland PTE returns. Under the Maryland statute, the tax is considered as a taxed imposed on the PTE itself.2
Without the election, the PTE would file Form 510 and pay a nonresident tax on the PTE’s distributable income with respect to any partners who are not residents of Maryland. The tax is computed at a rate of 8% on the Maryland distributive income to nonresident individuals, and 8.25% to non-Maryland entity owners. The tax is not considered an “entity level” tax and flows-through to the respective owners on their Maryland K-1s. A Virginia owner would then be required to file a Maryland nonresident individual income tax return (Maryland Form 505, Nonresident income tax return) to report their share of the Maryland source income. The Virginia owner would compute the Maryland individual income tax due on line 32(c) of Form 505. The taxpayer will then offset their Maryland tax due with the nonresident tax paid by the PTE on line 45.3 To the extent the Maryland nonresident tax paid by the PTE is higher than the actual tax due, the overpayment is refunded to the owner.
The Virginia owner would report income from all sources on their Virginia Form 760. The Virginia owner may claim a credit for tax paid to another state on line 24, and also complete Schedule OSC and provide a copy of the Maryland and other state income tax returns. The taxes due on Maryland Form 505, line 32(c) are creditable to the taxpayer in Virginia.
PTEs making the election would file the newly released Form 511.4 Electing PTEs are taxed on the entity’s taxable income. The PTE’s taxable income is defined as “the portion of a pass–through entity’s income under the federal Internal Revenue Code, calculated without regard to any deduction for taxes based on net income that are imposed by any state or political subdivision of a state, that is derived from or reasonably attributable to the trade or business of the pass–through entity in this State.”5 Tax rate is 8% on the share of income attributable to individual owners (whether they are residents or non-residents) and 8.25% for corporate owners. A Virginia individual owner would still receive a Maryland K-1 from the PTE and be required to file a Maryland nonresident individual income tax return (Maryland Form 505, Nonresident income tax return) to report their share of the Maryland source income. The Virginia owner would compute the Maryland individual income tax due on line 32(c) of Form 505. The taxpayer will then offset their Maryland tax due with the nonresident tax paid by the PTE on line 46. To the extent the Maryland nonresident tax paid by the PTE is higher than the actual tax due, the overpayment is refunded to the owner.
When computing Maryland taxable income, the electing PTE must add back the Maryland tax. Similarly, the Maryland individual income tax returns require individuals who wish to offset their Maryland tax liability with the payments made on their behalf, to include the taxes in their computation of Maryland taxable income.
The Virginia owner of a PTE making the Maryland PTE election would report income from all sources on their Virginia Form 760. The Virginia owner may claim a credit for tax paid to another state on line 24, and complete Schedule OSC and provide a copy of the Maryland and other state income tax returns. Their share of the taxes due on Maryland Form 505, line 32(c) should be creditable to the taxpayer in Virginia.
Va. Code Ann. §58.1-332(A) states:
Whenever a Virginia resident has become liable to another state for income tax on any earned or business income or any gain on the sale of a capital asset (within the meaning of § 1221 of the Internal Revenue Code), not including an asset used in a trade or business, to the extent that such gain is included in federal adjusted gross income, for the taxable year, derived from sources outside the Commonwealth and subject to taxation under this chapter, the amount of such tax payable by him shall, upon proof of such payment, be credited on the taxpayer's return with the income tax so paid to the other state.
However, no franchise tax, license tax, excise tax, unincorporated business tax, occupation tax or any tax characterized as such by the taxing jurisdiction, although applied to earned or business income, shall qualify for a credit under this section, nor shall any tax which, if characterized as an income tax or a commuter tax, would be illegal and unauthorized under such other state's controlling or enabling legislation qualify for a credit under this section.”
With respect to S corporations, Va. Code Ann. § 58.1-332 (C) states:
“For purposes of this section, the amount of any state income tax paid by an electing small business corporation (S corporation) shall be deemed to have been paid by its individual shareholders in proportion to their ownership of the stock of such corporation.”
Prior to the genesis of the state PTE elections, Virginia owners of a business filing a Maryland income tax return would be able to take a credit for the Maryland (and other state) taxes paid on the same income which was subject to Virginia income tax. With respect to the PTE election, the Virginia owner is still subject to Maryland income taxes on their share of Maryland source income from the PTE. The taxpayer is still required to file a Maryland non-resident income tax return. The tax is computed on the return, which the Virginia owner is liable for. The Virginia owner may provide a Maryland K-1 showing the amount of the tax that the PTE paid which is related to their share of the income. Thus, even if the entity makes the PTE election, the mechanics of the taxes paid at the state level remain the same as when no election is made. It is only the character of the tax for federal income tax purpose which has changed. The Virginia taxpayer is subject to Maryland income tax on the Maryland source income regardless of whether the election is made or not.
The language of Va. Code Ann. § 58.1-332 (C), which treats state income taxes paid by an S corporation as deemed to have been paid by the owners for purposes of the Virginia credit for taxes paid to other states further illustrates that an entity level tax may be creditable to a Virginia resident individual.
TAX has had a long-standing policy not to permit a credit for taxes paid to the District of Columbia including both the District of Columbia unincorporated and corporate franchise taxes. Virginia Public Document Ruling No. 95-257, 10/06/1995. Virginia Public Document Ruling No. 95-202, 08/03/1995. The distinction here is that the District’s taxes have been defined as “franchise” taxes, even though they are imposed upon net income. Furthermore, the District is prohibited from taxing non-residents under the Home Rule Act of 1973.6 Here, the PTE tax is defined by statute as an income tax and Maryland may and will tax Virginia residents on the Maryland source income, even if the PTE makes the election and pays the income tax.
In Stanley F. and Dorothy A. Pauley v. Virginia Department of Taxation, 55 Va. Cir 215, 05/01/2001, the Virginia Circuit Court upheld TAX’s assessment disallowing certain state entity level taxes due to being labeled as a franchise or privilege tax and also because states cannot impose an income tax on federal obligations under 31 U.S.C. § 3124. The Maryland PTE tax provides for an addback for interest from federal obligations. Thus, the Maryland PTE tax does not have the issues which TAX and the court found in the Pauley case with the tax regimes in California, Michigan, New York, Tennessee and Texas as they existed in 1996.
As mentioned above, many Virginia taxpayers, many of whom are small business owners, will be impacted by the Maryland PTE election. Some of the Virginia owners, being minority partners and/or shareholders will have the election made by the entity by being outvoted by their Maryland co-owners. While they may receive a federal benefit, it will be at the cost of having to pay tax to two states on the same income unless TAX confirms that based upon the mechanics of the Maryland PTE election, and the income subject to tax at the entity and individual levels in Maryland, that Virginia would in fact, allow a deduction for taxes paid to Maryland on the same income.7
While the focus of this letter ruling request is with respect to Maryland, since 2018, the following other states have enacted elective PTE elections: Alabama, Arkansas, Colorado, Georgia, Idaho, Louisiana, New Jersey, New York, Oklahoma, South Carolina, and Wisconsin. Connecticut also enacted a has a PTE tax, but the tax is mandatory. Each state has their own approach to how the election is made and the tax impacts at the entity level and owner levels. Notably, in response to surrounding states enacting pass-through elections, neighboring state tax departments have released guidance on their state’s position on credits for taxes paid to other states under such a regime such as Connecticut, California, Illinois, Massachusetts, Missouri, New York, and Pennsylvania.
As tax regimes continue to evolve, it is important that Virginia adapts in response to mitigate unintended consequences for Virginia taxpayers. Therefore, the Committee respectfully requests a ruling as to whether the credit for taxes paid to other states will be available to Virginia taxpayers who are owners of PTEs that make the Maryland PTE election and file Maryland non-resident individual income tax returns computing tax upon their share of the income.8
The Virginia Society of Certified Public Accountants (VSCPA) is the leading professional association in the Commonwealth dedicated to empowering CPAs to thrive. Founded in 1909, the VSCPA has more than 13,000 members who work in public accounting, industry, government and education. Please feel free to contact me or VSCPA Vice President, Advocacy Emily Walker, CAE, at (804) 612-9428 or [email protected] if we can be of further assistance.
Vivian J. Paige, CPA
Chair, 2021–2022 Tax Advisory Committee
Virginia Society of CPAs
CC: Secretary of Finance Joe Flores
Patrick Cushing — VSCPA Legislative Counsel
Recovery for the Economy, Livelihoods, Industries, Entrepreneurs, and Families Act (“RELIEF” Act). Maryland first enacted the PTE tax election in May 2020 via Maryland Senate Bill 523. However, this initial legislation only applied the PTE tax to Maryland residents’ share of income. The Relief Act updated the legislation to include all owners income (regardless of residency) raising the issue for Virginia residents.
In order to take credit for the non-resident tax paid on their behalf, the Maryland K-1 showing the owner’s share of nonresident tax must be attached to the return. If the K-1 is not provided or the K-1 is not correctly completed, the owner cannot take a credit for the payment made on their behalf.
The Maryland Comptroller’s Office released 2020 Forms 510 and 511 on June 29, 2021.
Maryland Senate Bill 787 of the Acts of 2021
Pub. L. No. 93-198; 87 U.S.C § 774
Subject to the limitation to the Virginia individual income tax rate.
Although enacted on February 15, 2021, the Maryland Comptroller’s office did not release the final 2020 forms until June 29, 2021. The election must be made on the originally filed Form 511 for the Tax Year the election will apply to. The Comptroller’s office, recognizing the delay in releasing the forms provided an extension of the 2020 due date for Maryland PTE returns to first, July 15, 2021 and then September 15, 2021. We therefore respectfully request that Tax opine on the matter as soon as possible in advance of the September 15 due date.