Beginning with the 2018 tax year, passthrough entities in the state of Connecticut are now liable for an income tax in the state of Connecticut levied directly on the passthrough entity. Generally speaking, the tax must be reported and paid via Form CT-1065/CT-1120SI, due on March 15th for calendar year filers. “Pass-through entities” in this context refers to both Partnerships and S-Corporations. For the uninitiated, it might at first seem odd that Connecticut would impose an income tax at the entity level for these passthrough entities; after all, the defining commonality that these entity types share is that the entity itself is not subject to income tax at the entity level, and this remains true at the federal level. Why, then, would the state of Connecticut deviate from the traditional tax treatment of these entity types in favor of a tax imposed directly on the entity, rather than on the owners of the entity? The answer is that by imposing the tax obligation directly at the entity level, the Connecticut legislature has provided Connecticut business owners with relief from the State and Local Tax (SALT) deduction limitation implemented under the Tax Cuts and Jobs Act (TCJA), enacted in December of 2017.
One of the most contentious of the sweeping changes to the tax code implemented by the Tax Cuts and Jobs Act was a cap placed on one's ability to include the payment of state and local taxes as an itemized deduction on one’s return. The TCJA limited the amount of SALT available as a deduction to $10,000 for individual and married taxpayers (the limit is $5,000 per return for married taxpayers who file separately). Previously, there was no limit to the amount of SALT a taxpayer could deduct.
Immediately, representatives from states with high state taxes (property, income, and sales taxes) began to protest the change as a tax hike disproportionately affecting their constituents. And almost as immediately, tax policy-makers from these high tax states began to search for a workaround to ease the federal tax burden on their taxpaying constituents. The initial workaround, championed by states including New York, New Jersey, Maryland, and Connecticut, entailed the establishment of a state charitable fund to which taxpayers could make contributions in exchange for an offsetting state tax credit. In this way, it was thought, the taxpayer could change the nature of their payment of state tax from a SALT payment (subject to the deduction limitations) to a charitable contribution, which is not subject to such a limitation. Unfortunately for state legislatures, the IRS nixed such attempt in regulations published in June of 2019. The IRS determined that taxpayers who make contributions under state and local tax credit programs in the expectation of the receipt of a state of local tax credit in return for the contribution has not truly made a charitable contribution, but rather has made a transfer of property in exchange for an equally valuable tax credit — a quid pro quo if you will. Thus, the contribution to the state charitable fund would not be truly charitable, and, in the eyes of the IRS, would therefore not be eligible to be deducted as a charitable contribution on the taxpayer’s return to the extent and offsetting state tax credit was received.
However, during the rule making process, the issue was raised that owners of passthrough entities might be able to to make contributions through passthrough business entities and, by characterizing contributions as business expenses under Section 162, pass the deduction down to its individual owners, thus circumventing the SALT limitation cap. In recognition of this potential workaround to the SALT limitation, on May 31, 2018, CT Governor Malloy signed Public Act 18-49, which established a new 6.99% entity-level tax on passthrough entities in the state for tax years beginning on or after January 1, 2018. The law provided for an offsetting credit on partners and S-corporation shareholders’ personal Connecticut income tax returns equal to 93.01% of the passthrough entity tax paid. This credit would provide a dollar-for-dollar credit on an owner’s personal return offsetting the tax paid by the passthrough entity. In doing so, the state income tax burden of passthrough income was shifted away from a SALT paid directly by the business owner (and subject to the $10,000 SALT limitation) and transmuted into a deductible business expense. By removing the recognition of income tax on passthrough income as a SALT paid by a business’ owner, Connecticut business owners that itemize their deductions will now be able to utilize property and general sales taxes to comprise their $10,000 SALT deduction, whereas previously these taxes may have been excluded if, when combined with state income tax paid, they exceeded $10,000 in aggregate. This represents an attractive tax benefit for Connecticut business owners.
On November 09, 2020, the IRS issued Notice 2020-75, formally blessing the passthrough entity tax as a legitimate workaround to the SALT limitation. While Connecticut was on the forefront of enacting such a scheme, expect a number of states to follow suit now that the workaround has been explicitly approved by the IRS. Unfortunately, being on the cutting edge of employing this new SALT workaround meant that the changes were implemented quickly and not widely publicized. In recognition of this, Connecticut has provided for a waiver of penalties for entities that may have failed to report and pay their passthrough entity tax for 2018. It also necessitated the amendment of a number of administrative procedures to address a number of questions stemming from the original legislation, such as the inclusion of guaranteed payments made by a partnership within the calculation of that partnership’s taxable income. These changes were enacted as part of the budget bill signed by Governor Ned Lamont in July of 2019.
Unfortunately, as is often the case with many legislative initiatives in Connecticut, the government took what initially was a change aimed at helping to reduce the federal income tax burden of taxpayers negatively affected by the SALT limitation imposed by Congress, and turned it into an opportunity to collect additional revenue from Connecticut taxpayers. The 2019 legislation modifying the provisions of the passthrough entity tax reduced the offsetting credit available to Connecticut taxpayers from 93.01% to 87.5% for tax years beginning on or after January 1st, 2019, meaning the credit will no longer fully offset the tax paid at the entity level. The workaround now, in fact, serves to increase the cumulative state income tax obligations of partners and shareholders in passthrough entities (though the workaround may still provide an overall tax benefit to taxpayers depending on their individual SALT situation). This credit reduction also had implications for nonresident partners and shareholders of Connecticut passthrough entities. Because the tax credit will no longer fully offset an individual partner or shareholder’s income tax liability to the state of Connecticut, nonresident partners and shareholders would be faced with a Connecticut income tax filing obligation. In response to these concerns, the DRS announced that they will allow Connecticut passthrough entities to file composite returns for non-resident members and remit the applicable tax owing on behalf of the nonresident members and shareholders. However, the the passthrough entity is not required to do so, and the nonresident partner or shareholder is only excused from this filing obligation if the entity elects to file a composite return and remit the applicable tax to the state.
While the intention of the state in enacting the passthrough entity tax was meritorious, it has complicated the filing obligations of Connecticut passthrough entities and their members, and the reduction in the available offsetting tax credit has served to increase the Connecticut income tax burden for many Connecticut taxpayers whose income is derived from passthrough entities. The SALT limitation is scheduled to sunset in 2025, and given the provision’s unpopularity, particularly among Democratic lawmakers presently set to control both the legislative and executive branches of the federal government for at least the next 2 years, it remains to be seen how long the workaround will even prove beneficial at the federal level. And it remains to be seen whether the changes, which have served to complicate the tax reporting obligation for many Connecticut residents and businesses, will be rolled back if and when the federal SALT limitation is sunset. Count me among the pessimists.