The Tax Cuts and Jobs Act placed a $10,000 cap on individuals’ deductions of state and local taxes (SALT) for federal income tax purposes. Since the law was passed, several high-tax states have explored workarounds to help ease the burden of the new limitation. One such response is Connecticut’s new pass-through entity tax.
Shifting Tax Liability
Essentially, the Connecticut pass-through entity tax shifts the income tax liability from an entity’s owners (partners or members) to the entity itself. Ordinarily, a pass-through entity does not pay tax on its income — instead, the owners are taxed on their allocable share of that income. For tax years beginning on or after January 1, 2018, however, pass-through entities are subject to an entity-level Connecticut state tax on their share of Connecticut source income, at a rate of 6.99% (the top marginal individual rate). The tax is deductible by the entity, thereby helping to offset the effect of the$10,000 limit on individuals’ SALT deductions by reducing their share of overall allocable income.
To ensure that the entity’s income isn’t taxed twice, Connecticut law provides owners with a tax credit to offset the tax on their share of the entity’s after pass-through entity tax income. The credit is equal to 93.01% of an owner’s direct and indirect share of a pass-through entity’s Connecticut tax liability (provided the pass-through entity has paid the tax before the owner claims the credit). If the credit exceeds an individual owner’s tax liability, the owner is entitled to a refund. Corporate owners can carry forward excess credits for use in later tax years.
Pass-through Entity Tax Calculation Methods
There are two methods of calculating the pass-through entity tax. The first, or default, method is to apply the tax to a standard tax base. The second is for pass-through entities to elect to use an alternative tax base.
Though there are many intricacies behind computing pass-through entity tax, the important thing to note is that affected entities — non-publicly traded partnerships, S corporations, and LLCs taxed as partnerships — will want to determine which base will provide the greatest tax advantage.
This past summer, the Connecticut Department of Revenue Services issued guidance on the pass-through entity tax and credit. Among the issues addressed were:
- Calculation of the tax base,
- The combined return election,
- Estimated tax payments,
- Allocation and reporting of owners’ tax credits, and
- Filing obligations of nonresidents.
Evaluating the Impact
Connecticut’s pass-through entity tax is a unique approach to help owners impacted by the new deduction cap to receive a tax benefit from their share of Connecticut state tax. Some states have set up charitable organizations to which individuals can contribute and from which they can receive a credit against their state or local income or property taxes. In August, the IRS released proposed regulations which seek to disallow deductions for charitable contributions made to many of these organizations to the extent in which a taxpayer receives a benefit for that contribution. At this time, it is uncertain whether or not the IRS will react to challenge the deductibility of the Connecticut pass-through entity tax.
If you own an interest in a pass-through entity that generates Connecticut source income, you can start preparing now by consulting with your Untracht Early tax advisor to evaluate the impact of the pass-through entity tax and to determine which tax base may be most beneficial for you.