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On May 31, 2018, Connecticut enacted Public Act No. 18-49 which includes a new pass-through entity (PTE) tax that applies to partnerships, limited liability companies treated as partnerships and S corporations.1
The Act also contains provisions that allow municipalities to provide a property tax credit to eligible individual owners of residential property who make donations to an approved “community supporting organization,” and other corporation business tax (CBT) and personal income tax provisions in response to federal tax reform provisions contained in H.R. 1, commonly referred to as the Tax Cuts and Jobs Act (TCJA).2
The new provisions are generally effective for tax years beginning on or after Jan. 1, 2018, unless otherwise specified.
Pass-through entity tax
The Act creates a new business entity level tax on PTEs or “affected business entities,”3
defined as partnerships, S corporations and limited liability companies treated as partnerships for federal income tax purposes, at a rate of 6.99%.
The PTE tax is generally calculated based on the affected business entity’s taxable income as determined for federal tax purposes under Internal Revenue Code (IRC) Sec. 702(a) on both separately and non-separately stated items flowing to equity holders to the extent they are derived from or connected to sources within the state as adjusted for state modifications.4
If the tax base adjusted for state modifications results in a loss, such loss may be carried forward until used in its entirety. Alternatively, an affected business entity may make an annual election to compute the PTE tax based on income associated with nonresident individuals and the portion of in-state residents’ income that is not taxed elsewhere.5
This alternative methodology is presumably designed to eliminate from the PTE tax regime any income associated with corporate or tax-exempt entities. Taxpayers will need to consider the tax impact of this election to determine whether such election would be beneficial to the partnership.
Each affected business entity’s individual shareholder, partner or member is allowed a Connecticut credit equal to a person’s direct and indirect pro rata share of the tax paid multiplied by 93.01%.6
If the amount of the allowable credit exceeds the person’s tax liability, the excess will be treated as an overpayment that can be refunded to the taxpayer.
Corporate PTE members of an affected business entity are permitted a similar credit, which is applied after all other credits are applied, but is not limited to 50.01% of the CBT liability as are other business credits.7
Any amount of credit exceeding the corporation’s CBT liability must be carried forward to succeeding tax years until fully utilized.
Combined filing election
The Act permits affected business entities to file a combined return with one or more other commonly owned affected business entities subject to the PTE tax.8
The term “commonly owned” means more than 80 percent of the voting control9
of an affected business entity is directly or indirectly owned by a common owner or owners, either corporate or non-corporate. The election to file on a combined basis must be made in writing to the Connecticut Department of Revenue Services (DRS) on or before the extended due date of the PTE return, and is required to include a consent for all included entities. Each affected business entity electing to file a combined return is jointly and severally liable for the tax due.
The Act requires affected business entities to make quarterly estimated payments.10
As the Act was enacted after the April 15, 2018, due date for the first estimated payment, the DRS recently issued guidance providing that PTEs may comply with their 2018 estimated payment requirements by:
- Making a “catch-up” payment with the June 15, 2018, estimated payment that satisfies both the first and second estimated payment requirements;
- Making three estimated payments (by June 15, 2018, Sept. 15, 2018, and Jan. 15, 2019), each equal to 22.5% of the tax liability (with the full amount of tax due by the return due date); or
- Annualizing their estimated payments for the taxable year.11
Additionally, Connecticut will allow PTEs to re-characterize all or a portion of any April 15, 2018, June 15, 2018, or Sept. 15, 2018, income tax estimated payments made by any of their individual partners, with such partner’s consent, so that the payments are applied against the PTE’s 2018 estimated payment requirements.12
The re-characterization of these 2018 income tax estimated payments must be completed by Dec. 31, 2018. The re-characterized amount will be deemed to have been made by the PTE on the date that the individual partner remitted the estimated payment to the DRS. The DRS will provide information by Sept. 30, 2018, on the mechanism to re-characterize these estimated payments.
Nonresident filing obligations
Nonresident individuals of an affected business entity generally are not required to file a Connecticut personal income tax return for tax years in which the PTE is their only source of Connecticut income and the PTE has paid the PTE tax.13
This exception does not apply to a nonresident individual who is a member of an affected business entity that elects to file on a combined basis (see discussion above) and the individual’s nonresident tax credit is insufficient to fully satisfy his or her Connecticut personal income tax liability.14
Previously, a PTE generally was required to file a composite return and pay the tax on behalf of any nonresident member for whom the PTE was the only source of Connecticut income.15
For taxable years beginning on or after Jan. 1, 2018, the Act eliminates the requirement to file composite returns for nonresident members.16
Tiered business entities
The Act provides that if an affected business entity (lower-tier entity) is a member of another affected business entity (upper-tier entity), the lower-tier entity is required to make adjustments in determining Connecticut taxable income.17
In effect, the lower-tier entity is required to subtract its distributive share of income or add its distributive share of loss from the upper-tier entity to the extent that the income or loss was derived from or connected with sources within Connecticut.
Property tax credit for contributions to municipal charities
Effective July 1, 2018, the Act allows Connecticut municipalities to provide a property tax credit to taxpayers donating to a designated community supporting organization.18
A “community supporting organization” is defined as an organization that is exempt from taxation under IRC Sec. 501(c)(3) and organized solely to support municipal expenditures for public programs and services.19
For the donation to qualify, it must be a voluntary, unrestricted, and irrevocable cash donation made by or on behalf of the owner of the property.20
The allowable credit cannot exceed the lesser of: (i) the amount of property tax owed; or (ii) 85 percent of the donation.21
The state has estimated that the budgetary impact of any town electing to utilize this option will be neutral, given that the funds received by the organizations will be made available to the municipality as a grant.22
Barring any IRS intervention, a taxpayer will be able to claim the donation as a charitable deduction for federal income tax return purposes.
Expense disallowance equal to 5% of dividends
The existing CBT law provides that corporations are not permitted a deduction for expenses related to dividends that are allowable as a deduction or credit under the IRC.23
However, effective for tax years beginning on or after Jan. 1, 2017, the Act modifies this statute to provide that expenses related to disallowed dividends equal 5% of all dividends received by a corporation during the income year.24
The net income associated with the disallowance of expenses related to dividends is required to be apportioned in accordance with existing apportionment rules. This provision is primarily intended to capture revenue from the one-time repatriation transition tax under the TCJA deemed dividend provisions under amended IRC Sec. 965. Interestingly, the 5% addback provision is applicable to all dividends, and is not only limited to IRC Sec. 965 income. Furthermore, the DRS has amended its official guidance in conformity with the expense disallowance provisions codified in the Act.25
Bonus depreciation addback and IRC Sec. 179 expense
The Act decouples Connecticut personal income tax law from the bonus depreciation provisions of IRC Sec. 168(k) enacted under the TCJA. Applicable to tax years beginning on or after Jan. 1, 2017 and to property placed in service after Sept. 27, 2017, any additional IRC Sec. 168(k) depreciation, to the extent deductible in determining federal adjusted gross income, is disallowed for individuals receiving income from PTEs.26
However, individuals may take a state deduction for 25% of the amount added back in calculating state adjusted gross income in each of the four succeeding tax years.27
For tax years beginning on or after Jan. 1, 2018, the Act requires individuals, PTEs and corporations to add back 80% of deductions under IRC Sec. 179,28
and 25% of the disallowed IRC Sec. 179 deduction may be claimed as a deduction in each of the four succeeding tax years.29
Decoupling from IRC Sec. 163(j)
For tax years beginning on or after Jan. 1, 2018, the Act requires that the deduction allowed for business interest paid or accrued must be determined under the IRC, except that the provisions of IRC Sec. 163(j) do not apply.30
The total impact of the TCJA on taxpayers and taxing jurisdictions is a controversial issue that continues to be debated by lawmakers and practitioners. It is incredibly difficult to accurately predict its effects this soon after its enactment. However, one outcome remains irrefutable: it has initiated state tax reform conversations nationwide. Affected states such Connecticut are enacting legislation to work around what they view as unfavorable tax provisions. For example, methods to reclassify tax dollars from state taxes to charitable donations is being discussed and implemented in several states, with the efforts of New York leading the way.31
Additionally, Connecticut lawmakers have leveraged the pre-existing ideology of a business entity tax and created a novel way to attempt to circumvent the $10,000 SALT deduction limitation in the TCJA to entice business and “protect” in-state residents. Unlike the charitable donation plan, the state is not reclassifying tax dollars, but instead shifting the tax to the entity level. Under the TCJA, the SALT deduction cap does not apply to businesses. With the entity paying the tax and the individual members receiving a refundable credit, the Connecticut legislature and Governor Dannel Malloy contend that additional tax is effectively rendered revenue-neutral.
The Act is not without detractors. Practitioners and lawmakers alike have questioned the staying power of the Connecticut provisions that are intended to circumvent the $10,000 SALT deduction cap, citing a potential Internal Revenue Service (IRS) challenge. Some tax practitioners have even noted that the property tax credit approach may in fact violate the pre-established IRS rules. According to the IRS, if a taxpayer expects to receive a benefit as a result of making a charitable contribution, the amount representing the benefit received cannot be deducted.32
Additionally, some claim that the creation of a business entity tax nullifies the inherent benefits of establishing a PTE. The number of taxpayers actually receiving benefits, as well as the overall constitutionality of this approach, are a couple of the more salient arguments against the adoption of a business entity tax. Although the tax is revenue-neutral and benefits affected taxpayers, the state is not providing an equal benefit for employees earning wages. Assuming the practice is not disallowed, wage-earning taxpayers will receive a benefit in the form of a property tax credit at a maximum rate of 85% of the individual’s tax rate. However, equity holders will receive a full dollar-for-dollar refundable credit. The constitutionality argument is based on the U.S. Supreme Court’s decision in Comptroller of the Treasury v. Wynne.33
the Court determined that the failure of state law to allow a credit against local personal income tax for a resident’s share of pass-through income taxed by another state was unconstitutional.34
If Connecticut does not permit credits for similar taxes imposed by other states, it could be challenged on constitutional grounds.
To date, with the exception of the Department of the Treasury’s recent pronouncement that it and the IRS will soon issue guidance on challenges to state tax enactments and proposals to work around the TCJA’s $10,000 SALT deduction cap,35
little is known of the IRS response or the evolution of the workarounds. With additional state-level reforms looming, it is increasingly important for taxpayers to understand the effects and staying power of the new legislation.
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