Hiccup in Mass. Pass-Through Entity Legislation

Beacon Hill is now experiencing a bit of a hiccup in its efforts to fashion some relief to co-owners of pass-through business entities from the annual $10,000 federal limitation on the allowance of taxes as an itemized deduction.

Though Massachusetts cannot unilaterally create a full-blown end-run around the federal limitation, the legislature has come up with a creative way of generating a deduction for such co-owners, by converting a state income tax into an excise tax.  House Bill No. 4009, “An Act relative to the taxation of pass-through entities,” was re-enacted on August 2, 2021, after a rejection of an amendment proposed by the Governor.  As enacted by the legislature, the Act would provide an option for any pass-through business entity (including a partnerships, S corporation or LLC treated as either of those) to pay an excise tax equal to 5% of its income taxable in Massachusetts.  Each co-owner could then claim a refundable tax credit of 90% of his or her share of the excise tax.  This legislation reportedly is modeled after a 2020 Connecticut law.

In a message dated August 3, 2021, however, the Governor vetoed that legislation, asserting (again) that the credit should be 100%, not 90%.  It will be taken up again by the House. It seems likely to be enacted eventually, likely with the legislature overriding the Governor’s veto.

The legislature’s limitation of the owners’ refunds to 90% of the tax could be justified as an attempt to provide some better substance to the excise tax.  A tax which is potentially refundable in full to an entity’s owners might seem to lack much substance.

Even at a 90% credit rate, the optional excise tax will be attractive to many pass-through entities, including those in which BEPC members participate and those that BEPC members advise.

As yet untested is the premise that a state’s labeling of a tax as an excise tax is enough to negate its character as an income tax – and thereby remove it from the list of taxes subject to the $10,000 limitation – where it is determined solely by the entity’s taxable income.  If the federal tax deduction ultimately failed, the optional excise tax would, at a 90% refund rate, turn into a loser for the co-owners.  On the other hand, if the federal deduction was upheld, sole proprietors might have an incentive to refashion their businesses as pass-through entities.