Connecticut’s Response to Federal Tax Reform Includes a New Tax on Pass-Through Entities
On May 31, 2018, Connecticut Governor Dannel P. Malloy signed legislation that includes a provision that shifts the burden of income taxes to pass-through entities. Senate Bill 11, titled An Act Concerning Connecticut’s Response to Federal Tax Reform, contains a number of provisions intended to respond to the “negative effects” of federal tax reform, referred to as the Tax Cuts and Jobs Act. Under federal tax reform, the state and local tax (“SALT”) deduction for individuals is limited to $10,000, however, no such limitation applies to business entities. The new law is intended to shift the burden of the income tax from individuals to business entities.
Retroactive Repeal of Composite Requirements
Under prior law, pass-through entities were not subject to tax based on income. Instead, such entities remitted tax via a composite return on behalf of nonresident individual partners, members or shareholders (“partners”). The composite filing requirements have been repealed effective January 1, 2018.
Overview of New Pass-Through Entity Tax
Under the revised law, pass-through entities, including partnerships, LLCs treated as partnerships, and S corporations are required to pay an entity-level tax at the rate of 6.99% on Connecticut-sourced income. Returns are due on or before the 15th day of the third month following the close of the entity’s taxable year (i.e., March 15 for calendar-year taxpayers). Composite returns were due on April 15.
The new law provides for various elective provisions, including an election to file on a combined basis with commonly owned entities (using an 80% voting test) as well as a provision to compute the tax base using an alternative basis, which is intended to mitigate the impact on corporate partners. In addition, the new law has specific provisions designed to mitigate the impact on tiered business structures.
Unlike other so-called workaround programs regarding the federal SALT deduction, the new pass-through entity tax is not elective.
Estimated Tax Requirements
Pass-through entities are required to remit estimated tax on a quarterly basis (April 15, June 15, September 15 and January 15 for calendar-year taxpayers). Connecticut has issued a special notice, SN 2018(4), providing guidance regarding the estimated tax requirements under the new tax. The special notice indicates that it will allow pass-through entities to re-characterize payments made at the individual level for the April 15, 2018, June 15, 2018, and September 15, 2018, payments. The special notice also provides procedures for making catch-up payments and to request relief for underpayment penalties relating to the new tax.
Offsetting Credits for Taxes Paid By Pass-Through Entities
Individual partners are entitled to a refundable credit equal to 93.01% of the pro rata share of tax paid by the pass-through entity. Connecticut residents must claim the credit on their personal income tax returns, Form CT-1040.
Similarly, corporate partners are entitled to a credit of 93.01% of the pro rata share of tax paid by the pass-through entity, but the excess credit must be carried forward and is not refundable. By giving the partners a credit for 93.01%, the partners remain subject to tax on 6.99% of the income generated by the pass-through entity.
Revisions to Filing Requirements for Nonresidents
Starting in 2018, nonresident partners of pass-through entities are generally not required to file a Connecticut personal income tax return if (1) their only source of Connecticut income is from a pass-through entity; and (2) the pass-through business has paid the entity tax. However, a nonresident personal income tax return must be filed if (1) the pass-through entity files a Connecticut return on a combined basis with other pass-through entities; or (2) if a partner’s personal income tax would not be entirely satisfied by the credit the partner earns from the business entity.
Charitable Deduction Workaround Provision
The legislation also included a new property tax credit to certain individuals who make voluntary payments to municipally approved organizations. Note that the IRS has announced its attempt to issue regulations to address the deductibility of such payments as charitable contributions. See Notice 2018-54. It is possible that such IRS guidance may address the pass-through entity tax as well. Some states may issue guidance regarding the ability to claim a resident credit for payments made by the pass-through entity.
Other Provisions Decoupling from Federal Tax Reform
In addition to the changes related to the SALT deduction, the legislation also enacts a new 5% expense disallowance for dividends related to Section 965 (repatriated) income, decouples for the new interest expense limitations, and spreads out both the federal 179 deduction (for corporations and individuals) and the federal bonus depreciation deduction (for individuals) over a five-year period.