Massachusetts temporarily decouples from OBBBA provisions

QOZ conformity

Qualified Opportunity Zones (QOZ) allow taxpayers to defer tax on capital gains by rolling those gains into a Qualified Opportunity Fund (QOF) within 180 days, postponing capital gain recognition until the earlier of the date the QOF investment is sold or a statutory deadline. Further, holding the QOF investment for the applicable holding periods provides a basis step-up that can reduce the deferred gain and potentially eliminate any gain related to the post-investment appreciation in the QOF.

The budget bill decouples Massachusetts from Sec. 1400Z-2 under the OBBBA, requiring taxpayers to utilize Sec. 1400Z-2 as in effect for tax years beginning before Jan. 1, 2026.¹²

Further, the budget bill limits the definition of “qualified opportunity zone” to areas entirely within Massachusetts that are federally designated as a QOZ under Sec. 1400Z-2.¹³ This limiting provision applies to tax years beginning on or after Jan. 1, 2026.¹⁴

IRC conformity

The bill also makes a broader structural change to Massachusetts’ IRC conformity. Although Massachusetts historically operated as a rolling conformity state, wherein the state automatically adopts changes made to the IRC, this bill creates an automatic decoupling rule for certain federal IRC amendments that affect either Massachusetts gross income or deductions. For tax years beginning on or after Jan. 1, 2026, Massachusetts will automatically decouple from IRC amendments for the tax year beginning in the calendar year in which the federal amendment is enacted and for prior tax years.¹⁵

This automatic decoupling rule is subject to an exception for amendments that the Massachusetts Department of Revenue determines will have a revenue impact of less than $20 million, measured on a rolling three-year average adjusted for inflation. In effect, Massachusetts will automatically decouple from an IRC amendment (unless the amendment does not meet the revenue threshold) for the year in which the amendment is enacted. However, the legislation impliedly conforms to the IRC amendment for future tax years as long as Massachusetts does not enact a permanent decoupling provision with respect to that amendment.¹⁶

PTET updates

Prior to this bill, the Massachusetts’ PTET regime permitted an eligible pass-through entity (PTE) (e.g., partnerships, S corporations, etc.) to annually elect to pay a 5% entity-level tax on their “qualified income taxable in Massachusetts” (effectively either the nonresident’s distributive share of Massachusetts-sourced income or a Massachusetts resident’s full distributive share of pass-through entity income).¹⁷ However, since the 2023 tax year, Massachusetts imposes an additional 4% surtax on income exceeding $1 million.¹⁸

Although the enactment of the surtax to personal income taxation appears straightforward, the implementation of the surtax has been inconsistent. For example, the Department issued guidance indicating that the surtax should be withheld for personal income tax purposes, but for nonresident withholding and/or composite filing purposes, the surtax was not included in the tax base.¹⁹

H.B. 5470 creates an additional state elective PTET for the 4% surtax.²⁰ A PTET is intended to allow individuals owning PTE interests to deduct, for federal income tax purposes, the annual limitation for the state and local tax deduction. This regime allows an eligible PTE to make an annual election to pay an excise tax on its “qualified income taxable in Massachusetts” at a 4% rate.²¹

Qualified taxable income is defined and determined the same as under the standard PTET regime except for the purposes of this election, it is limited to the “sum of the amounts by which the amount allocated to each qualified member exceeds the” $1 million surtax threshold.²²

Qualified members of the PTE (individuals, trusts, or estates) are allowed to claim refundable credits on their respective Massachusetts returns. However, the credit is limited to 90% of the PTET paid by the PTE.²³ All members of the electing PTE are bound by the election, which is irrevocable for the year made.²⁴ This new PTET regime is applicable for tax years beginning on or after Jan. 1, 2026.²⁵

Commentary

As states are currently seeking various means to raise revenue and to fulfill balanced budget requirements, Massachusetts sought to decouple from key provisions of the OBBBA as full conformity was estimated to result in a negative $442 million revenue impact.²⁶ Notably, Massachusetts chose not to seek additional revenue through enacting new taxes such as a digital advertising tax or taxes on prediction markets.²⁷

As noted above, with revenue considerations top of mind, the OBBBA conformity provisions had specific rules which would have been affected prospectively, had Ballot Initiative 25-18 been approved by voters this November. Specifically, several OBBBA decoupling provisions would have remained in effect in an attempt to offset the revenue that would have been lost under the ballot initiative. The Massachusetts Supreme Judicial Court’s decision is noteworthy in how it reached its decision to void the initiative.

To understand the decision, a review of the Massachusetts personal income tax statutory classifications is necessary. Massachusetts’ personal income tax regime is an outlier compared to other states in that it classifies individual income into three statutory categories:

• Part A: interest, dividends, and those capital gains that are not Part C income;
• Part B: all income that is not Part A or Part C income; and
• Part C: long-term capital gains, i.e., gains from the sale or exchange of capital assets that have been held for more than one year.²⁸

In some cases, these income classifications are subject to some interrelated rules.²⁹ Ballot initiative 25-18 would have reduced the 5% income tax rate on Part B income, which would in effect also reduce most Part C long-term capital gains. As noted in the Court’s decision, the Massachusetts attorney general’s summary described the measure as lowering the rates on “(1) personal taxable income consisting of interest and dividends, and (2) personal taxable income other than interest, dividends or capital gain income, such as wages and salaries.”³⁰

Accordingly, the Court found that because the petition would, in effect, lower the tax rate on capital gains, a reasonable voter would be misled by the summary and enjoined the Massachusetts Secretary from placing the initiative on the 2026 ballot.

Ultimately, the Massachusetts Supreme Judicial Court’s rejection of the ballot effectively has provided taxpayers with more certainty with respect to the prospective application of several business OBBBA provisions. However, the bill’s broader IRC conformity changes may be the most significant long-term development that arises from the Massachusetts budget bill. Rather than abandoning rolling conformity altogether, Massachusetts modifies its approach to conformity, similar to Maryland, by creating an automatic decoupling rule for the year in which a new IRC amendment results in a significant revenue impact.

This approach differs from a pure static conformity model because Massachusetts will provide an automatic mechanism to pause the effect of major federal tax amendments while revenue impacts are evaluated by the state legislature, with implicit coupling to the IRC amendment in future tax years if the legislature does not address the IRC amendment with a permanent decoupling provision. Taxpayers should therefore monitor not only whether Massachusetts has enacted specific decoupling provisions, but also whether future federal amendments fall within the new automatic decoupling framework or qualify for the revenue-impact exception.

The retroactive application of several OBBBA decoupling provisions may create practical compliance issues for the 2025 tax year. Taxpayers may have calculated estimated tax and extension payments before Massachusetts enacted H.B. 5470 and therefore may not have accounted for the state’s decoupling from Secs. 174A, 163(j), 168(n), and 179. Corporate taxpayers generally should be able to address any additional liability through the return filing process, particularly given the bill’s penalty and interest relief for retroactive conformity changes.

PTEs, however, may face additional administrative burdens if prior nonresident withholding payments were calculated without taking these retroactive adjustments into account. Similar to New York, Massachusetts does not permit PTEs to remit additional nonresident withholding tax on timely filed returns. Accordingly, PTE taxpayers with a significant Massachusetts presence may have under-withheld on behalf of their nonresident partners. Because Massachusetts generally does not permit PTEs to “true-up” under-withheld nonresident withholding tax on a timely filed return, under-withholding may create significant compliance and administrative issues, particularly in tiered partnership structures.

The new elective PTET for the 4% surtax also raises planning considerations. The regime intends to extend the benefits of Massachusetts’ existing PTET framework to income subject to the surtax, but the mechanics may not fully align with every ownership structure. In particular, because the surtax PTET is tied to qualified income exceeding the $1 million surtax threshold, taxpayers should evaluate whether the election produces the intended benefit where an individual receives Massachusetts-source income through multiple PTEs.