Press Room: Tax Release
Connecticut Enacts New Pass-Through Entity Income Tax
Connecticut recently passed legislation (S.B. 11) that imposes a new tax on any entity treated as an S corporation or partnership for federal tax purposes. The motivation behind the new entity-level tax is rooted in the impact of recent federal tax reform changes as the new tax seeks to mitigate the negative effects of the new limit on itemized deductions for state and local taxes under federal law.
The Tax Cuts and Jobs Act (TCJA) included a provision to disallow itemized deductions for state and local taxes of more than $10,000. The limits on this deduction would have a negative effect on owners of Connecticut businesses operating as pass-through entities, even with a lower marginal federal tax rate. The revenue-neutral state tax on pass-through entities and their owners enacted by Connecticut would theoretically eliminate the cap on the state tax deduction for federal income tax purposes. Connecticut would shift the non-deductible individual income tax to a deductible business tax on pass-through businesses as under the TCJA there is no limitation on the state and local taxes that are directly imposed on business entities. A credit for the entity-level tax would then be available to the owners of the businesses to apply against their Connecticut personal income taxes.
The new legislation imposes a 6.99% tax on pass-through entities, which is the highest marginal rate for the Connecticut income tax on individuals. The tax is imposed on either the pass-through entity’s taxable income, or an alternative tax base. Taxable income includes federal net income under Sec. 702 from Connecticut sources modified by Connecticut addition and subtraction adjustments from Connecticut sources. The addition and subtraction adjustments are those that apply to personal income taxpayers. In determining taxable income, the pass-throughs must also use sourcing rules that apply to personal income taxpayers.
The tax is offset by a tax credit at the personal income tax level equal to 93.01% of the pass-through entity owner’s pro rata share of the tax paid by the pass-through entity. The tax does not apply to publicly traded partnerships that agree to file an annual Connecticut partnership return and report certain information of unitholders with more than $500 in distributive income from Connecticut sources.
By way of example, assume that A and B are equal members of an LLC and that the LLC has net income of $100,000. Under the new legislation, a tax is now imposed on the LLC at a rate of 6.99%, for $6,990 of Connecticut income taxes. The LLC will deduct this amount on its federal income tax return, reducing its net income to $93,010. A and B will therefore each report half of the lower amount ($46,505) as income on their federal and Connecticut income tax returns. The pro rata share of the new Connecticut tax will be one half of $6,990, or $3,495. Due to the credit (93.01% of $3,495 = $3,251) and the reduced income reported by A and B, they will be in generally the same economic position as under pre-2018 law before state and local tax deductions were limited.
The new tax applies to tax years of pass-through entities beginning on or after January 1, 2018. Pass-through entities must make estimated tax payments, similar to those which the owner of the entity previously paid. The owners will now need to make corresponding reductions to their estimated tax payments.
The new entity level tax on pass-through entities is one of two workarounds that Connecticut has enacted in response to the limits on state and local tax deductions under the TCJA. The other is a property tax credit that authorizes municipalities to provide a property tax credit to those donating to certain designated community support organizations. The property tax credit is similar to provisions passed in New York and New Jersey; however, Connecticut’s new tax on pass-through entities is a unique approach and different from the workarounds proposed by other states.
IRS recently announced its intent to issue proposed regulations addressing the federal income tax treatment of certain payments made by taxpayers for which taxpayers receive a credit against their state and local taxes. In its announcement, IRS stated that despite state efforts to circumvent the new limitation on state and local tax deductions, federal law controls the proper characterization of payments for federal income tax purposes. It is uncertain whether IRS will challenge the approach taken by Connecticut in the context of their pending regulations.