Connecticut’s New Pass-Through Entity Tax: Practical Considerations
On May 31, 2018, Connecticut enacted a new pass-through entity (“PTE”) tax as an intended workaround to the $10,000 cap on state and local taxes (“SALT”) enacted as part of federal tax reform last December (see S11 (PA 18-49); see also Connecticut’s Response to Federal Tax Reform Includes a New Tax on Pass-Through Entities; What Law Firms Need to Know About Connecticut’s New Tax on Pass-Through Entities).
Basics of the New PTE Tax
PTE’s are required to pay tax equal to 6.99% of Connecticut-sourced income. Assuming an entity has $500,000 of Connecticut-sourced income, the new tax is $34,950 (6.99% times $500,000). Individual partners and corporate partners are entitled to a credit equal to 93.01% of the pro rata share of the tax paid by the PTE. Had the individuals paid the Connecticut tax directly, the tax would have subject to the $10,000 SALT cap. By shifting the burden of the tax to the PTE, Connecticut’s intention is to covert the tax paid into a business expense while receiving substantially the same amount of Connecticut tax.
The PTE tax is effectively retroactive to January 1, 2018 and repeals the composite return requirements. Formerly, Connecticut required PTEs to make a composite payment (similar to nonresident withholding) on behalf of nonresident partners on an annual basis. Unlike the composite requirements, the PTE tax is based on all Connecticut-sourced income – not just income attributed to nonresidents. Further, the PTE tax requires quarterly estimates – see our prior posts for details regarding compliance requirements.
Alternative Tax Basis
There may be situations where Connecticut residents would not benefit from the PTE tax as calculated above. For example, if there is no income from Connecticut sources, the PTE tax would be $0, and the Connecticut resident would continue to pay tax on all income from the PTE without any offsetting credits. In these situations, PTEs should consider making the election to use the alternative tax base, which, to simplify, is equal to the percentage interest of its Connecticut resident owners multiplied by its income (regardless of source). The effect of making the election would be to have the PTE tax computed on all income not sourced to Connecticut (or other states) and attribute such income to the resident partners. As a result, the tax that would have been due by the resident individuals (and subject to the SALT cap) becomes a business expense of the PTE. Connecticut has issued detailed guidance regarding the computation of the tax, including the mechanics of the alternative tax basis (see OCG-6, Regarding the Calculation of the Pass-Through Entity Tax).
Other Practical Considerations
Under the former composite return system, nonresident individuals (e.g., residents of New York or New Jersey) were generally allowed a credit for other taxes paid with respect to composite income tax payments made to Connecticut. Under the new law, because the tax is paid at a pass-through entity level, it remains to be seen whether other states would allow a credit for such taxes. For example, if an S corporation pays the PTE tax in Connecticut, presumably New York would not provide any resident credit for such taxes pursuant to N.Y. Tax Law Sec. 620(d) (“In the case of a shareholder of an S corporation, the term ‘income tax’ in … [OMITTED] shall not include any such tax imposed upon or payable by the corporation.”
Another important consideration is whether Connecticut’s PTE tax will accomplish its intended result of converting an individual tax (which would be subject to the SALT cap) into a business tax expense. The Internal Revenue Service has issued a notice indicating its intention to issue regulations regarding state workaround programs – focusing on charitable contribution workarounds (which Connecticut has also enacted) (see IRS Notice 2018-54). As a result, PTEs and their owners are required to go through the exercise of paying the PTE tax, with the potential that they will be in the same position they were in prior to the new tax regime.
Finally, by shifting the burden of the Connecticut tax to the PTE, the new tax becomes an additional cost and compliance burden at the PTE level. The additional costs are likely to impact the PTE’s performance and affect the business dynamics between the PTE and its owners.