The statutory language adopted by the Legislature is relatively short in length, but, as with any newly adopted provisions, open to interpretation, depending on how one parses that language.
As of now, no guidance has been provided by the Massachusetts Department of Revenue. Much of the strategies under consideration will change, depending on how the Department interprets the provisions enacted by the Legislature.
To begin with, an entity must be one of the specified types to be able to make an election to be taxed under these provisions: an “S” corporation; a partnership; or a Limited Liability Company (“LLC” in shorthand) AND is treated as taxable under the sections of the Internal Revenue Code relating to such entities (Section 1361 for “S” corporations or Section 7701 for partnerships). Excluded from use of these provisions are Grantor Trusts and Disregarded Entities (DREs). In this second category are “Single Member LLCs”, where a sole proprietor or landlord registers the business or property as an LLC with the state, but wholly owns the operation, these provisions may not be elected. Another open question is whether certain trusts (mainly liquidating trusts set up to collect amounts in dispute) that are treated as partnerships under federal law will or will not rise to the level of a specified entity under this language to avail themselves of this tax strategy.
This provision is only available for tax years beginning on or after January 1, 2021. Thus, fiscal years that began in 2020 and will conclude in 2021 will NOT be able to avail themselves of this election until their tax year that commences in 2021.
The election applies only to Massachusetts sourced income of specified electing entities. If income is apportioned to another state, the entity tax may not be invoked for that income. If and to the extent that income consists of investment income, such income is not sourced to any state and will not be subjected to the entity tax. This will preclude using a partnership to hold investments and seeking to pay the Massachusetts tax through the partnership to gain a deduction that would otherwise not be possible, due to the itemized deduction limitation on Schedule A for taxes.
Only specified members of an electing entity are subjected to the tax. Shareholders of an “S” corporation or members of a partnership that are either a “natural person”, an estate or a trust (these are the permitted shareholders for an “S” corporation) are subject to this method of taxation, if the entity elects this tax treatment. Thus corporations are NOT subject to such taxation and the income from Massachusetts sources are exempt from this tax treatment. The tax imposed under these provisions are treated as an entity expense and would be allocated, proportionately, among the partners or members. Thus, a deduction generated with respect to the specified members would, under Federal principals, be shared with the disqualified members.
There is some question as to how this scheme will work when the entity involved is one of a “chain” of such entities. If the operating entity is, in whole or in part, owned by another partnership, is the operating entity required to calculate and pay the entity tax or is the investor entity as a partner obligated to make an election and withhold as to partners among its owners that are specified members and only as to the Massachusetts sourced income, as determined by the operating entity? Guidance is needed from the Department of Revenue as to how the statutory provisions will operate in such a situation. Of course, this is a relatively simple situation, that can become much more complicated, the greater the number of entities in the “chain”.
Income is determined under Chapter 62 of the Massachusetts statutes. These are the provisions applicable to individuals and relate to the 2005 Internal Revenue Code, unless specifically excepted. Corporations are subject to tax under Chapter 63, which automatically updates to the Internal Revenue Code as it exists for the tax year in which a tax is imposed on the corporation.
The statute states that this is an “excise” that is “in addition to, and not in lieu of, any other Massachusetts tax required to be paid, including tax imposed by chapter 62 or chapter 63.” If this is not an income tax and is in addition to the otherwise due income tax imposed on the specified partners/shareholders, does the statute “dodge” the argument that it is unconstitutional, since the tax imposed, between the entity tax and the net income tax on the same income reported by the member/shareholder? This is due to the 90% limitation on the benefit of the credit, yielding an additional 0.5% to the state and being that much more than the tax that is imposed on a sole proprietor with the same business subject only to a 5% rate.
A member whose income is subjected to the entity level tax is to claim a share of the tax in proportion to their participation in the entity. The credit is refundable, but is limited to 90% of the allocated tax. The credit is claimed for the tax year within which the entity’s tax year ended. This means that for entities with fiscal years currently in progress, if that entity elects the tax, the owner who is allocated a credit will not be able to claim that credit until they file their 2022 tax return. The tax must be both “due” and “paid” by the electing entity. The question has been posed if “paid” in this context means paid within the tax year for which the credit is to be claimed or settled up with the filing of the tax return in which the tax is computed and any amount in excess of estimates paid (which are required in the same fashion as for individuals and corporations) will qualify. Is the “S” corporation in a better position, relative to a partnership, since its deductions are permitted under chapter 63, with the ability to accrue this tax, whereas the partnership is governed by chapter 62 and with the “paid” provision, previously discussed, may not be able to accrue, deduct and credit amounts not paid by year end (typically December 31, due to the requirement to use the calendar year as its reporting period)? Again, guidance is needed from the Department as to what interpretation will apply to this situation.
The election is made, annually, and, once made, is irrevocable for the year made. The election is not available for any year for which the limitation on itemized deductions for taxes is not in effect. Presumably, even if the limitation is modified (to a higher deduction amount), it would still be a limitation and this provision may be elected by a specified entity.
2021 STRATEGY: If an election is contemplated for this year, an evaluation of the effect of all of these issues needs to be done and well before year end. Some of the possible issues (sharing of deductions in a partnership with non-specified partner/members, etc.) would need to be evaluated and if significant, a decision made as to whether the income disparities are too substantial relative to the federal benefit to be received to support using this strategy. Also, should a cash basis entity desire to elect this provision, in the absence of guidance as to the interpretation of “paid” amounts for credit allowance, to be sure that the deduction and credit are allowable for Massachusetts purposes, payment of any amount for such purposes should likely be made no later than December 31, 2021. Currently, there is no means in place for submission of such payments. Further, if such amounts are significant, planning for adequate liquidity to be able to make the payments contemplated will need to be done to avoid a dishonored check tendered in payment of the tax(es).
Mark H. Misselbeck, C.P.A., M.S.T. is a Tax Principal at Katz, Nannis + Solomon, P.C. If you have any questions or would like to speak with one of our tax professionals, please contact our office at 781-453-8700.