Connecticut Changes Pass-Through Entity Tax
In June 2023, Connecticut Governor Ned Lamont signed into law HB 6941, which included numerous changes to the Connecticut Pass-Through Entity Tax (“CT PTET”) effective for tax years beginning in 2024.
The highlights of those changes include:
- The CT PTET is effective for tax year 2024.
- The CT PTET will be optional rather than mandatory and will be an annual election.
- The election will be due on the date of the return, including extensions.
- The due date of the return and CT PTET election will remain the 15th day of the third month following the close of the tax year.
- An electing pass-through entity (“PE”) will be required to use the alternative base to calculate the PE’s taxable income. When using the alternative base, the PE is subject to tax on (1) the portion of its Connecticut-sourced income (minus any Connecticut-sourced income from subsidiary PEs) that directly or indirectly flows through to members who are residents and nonresident individuals, trusts and estates; and (2) the portion of the PE’s total income that is not sourced to any state with which the PE has nexus (unsourced income) that directly flows through to members who are resident individuals.
- PEs are now required to file a composite return and withhold tax on the distributive share of nonresident member taxes when the PE’s business is the partner’s/member’s/shareholder’s only source of Connecticut income.
- The bill eliminates the option for PEs to file a combined return with one or more commonly owned pass-through entity or entities.
- The PE tax credit remains limited to 87.5% of the PE member’s direct and indirect pro-rata share of the tax paid by the PE on his/her behalf.
Connecticut was the first state to enact the PTET and, until now, was the only state that had a mandatory PTET. For tax years beginning on or after January 1, 2024, Connecticut will now follow the other 35 states that have enacted PTETs in response to the federal limitation on the itemized deduction for state income taxes paid with an elective PTET.
PEs that previously were required to pay PTET may now determine whether it would be beneficial to elect to be subject to the tax on an annual basis. Given the requirement to use the alternative base to calculate the PE’s taxable income, the amount of tax due under the elective PTET will depend on the type of partners/members/shareholders in the PE (e.g., individual resident versus individual nonresident). For nonresidents, the amount of income subject to the CT PTET will be their portion of the CT source income (as nonresidents cannot get the benefit of the unsourced income). For residents, the amount of income subject to the CT PTET will include both the CT-sourced income and the resident partner’s/member’s/shareholder’s portion of the unsourced income.
Quarterly estimated payments for the electing CT PTET are required if the PE’s tax due is expected to exceed $1,000. Quarterly estimates are due on the 15th day of the fourth, sixth and ninth months of the current taxable year and the 15th day of the first month of the next succeeding taxable year. If a cash basis PE wants to get the benefit of the fourth quarter payment in the current year, it should consider paying the fourth quarter estimated by December 31 of the tax year. Cash basis taxpayers get the federal deduction for taxes paid in the year the PTET is paid. Additionally, Connecticut allows for the use of the annualization method when calculating estimates.
Along with the requirement to pay the PTET quarterly payments, the legislation now requires PEs to file a composite tax return on behalf of their nonresident members for whom the business is the only source of CT income. This places an additional compliance obligation on the PE.
The CT PTET may not be beneficial to, say, all law firms as some firms may not have any unsourced income or have resident partners. Unsourced income is defined as the portion of total income that is not sourced to any state. The sourcing of receipts of service providers are based on either market-based sourcing or cost of performance. With market-based sourcing, receipts are sourced to the state where the customer receives the benefit of the services. With cost of performance, the receipts are sourced to the state where the services are performed. One way for a law firm to have unsourced income is to have a client who resides in a cost-of-performance state (such as Virginia) or that has a trial in a such a state and the law firm operates from outside a market-based state (such as California) and does not have any employees or perform any services in the cost of performance state. Those receipts would be considered unsourced receipts and would not be sourced to any state. However, absent a situation where a trial is conducted using video conferencing only, most attorneys who have trials in other states will most likely perform that trial in a courthouse in that state, and the receipts would be sourced to that state.
The alternative-base method of computing the CT PTET favors resident partners/members/shareholders as only resident partners/members/shareholders get the benefit of the unsourced income. If a law firm does not have any Connecticut resident partners/members/shareholders and does not have a large amount of Connecticut sourced income, it may not be beneficial to make the election to pay the CT PTET. Also, it is more difficult for law firms to have unsourced income as described above.
With all these considerations and the various intricacies within the CT PTET law, it is important to consult with your tax advisors to properly plan for the CT PTET.
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