New Connecticut Tax on Passthrough Entities – Effective January 1, 2018May 25, 2018
Tony J. Switajewski, CPA, MST
On February 12, 2018 I wrote an article titled “Connecticut Governor Proposes Passthrough Entity Tax to Help Connecticut Business Owners.” As the article explained, the goal of the proposed tax was not to create an additional income tax burden on passthrough entities and their owners, but rather was to provide a revenue-neutral workaround to the $10,000 state and local tax itemized deduction limitation imposed by federal tax reform. This legislation has been passed by the General Assembly and has been presented to Governor Malloy for his signature.
On May 9, 2018 the Connecticut legislature passed Public Act 18-49 (the “Act”), which is, in part, Connecticut’s response to the 2017 federal tax reform. Included in the Act is a new Connecticut income tax imposed at the entity level on passthrough entities (“PE”), such as partnerships (including limited liability companies treated as partnerships) and S corporations (the PE tax does not apply to sole proprietorships or single member limited liability companies, treated as disregarded entities or regular corporations). To make the tax revenue-neutral (i.e., a wash), a corresponding tax credit is allowed against the owner’s (non-corporate and corporate) Connecticut income tax liability.
In essence, the goal of the tax is to push the Connecticut income tax deduction from the owner to the PE business, thus allowing the PE owner a federal income tax benefit from the state income tax deduction (via the passthrough of reduced federal taxable income, after the state income tax deduction). Because the PE’s passthrough income will be subject to Connecticut income taxation again (through the taxation of an individual owner’s adjusted gross income (AGI) or a corporate owner’s corporate business income), to mitigate double Connecticut income taxation on the same income, a tax credit is allowed to owners to reduce their Connecticut income tax liability.
The Basics of the Tax: Effective for tax years commencing on or after January 1, 2018, the tax legislation imposes an income tax on a PE’s taxable income at a flat tax rate of 6.99% (currently, the highest individual marginal tax rate). Taxable income is determined under one of two methods: (1) Connecticut Source Income Method, or (2) Alternative Tax Base Method. The alternative tax base method will likely be chosen in the vast majority of situations in order to obtain the maximum federal income tax benefit, although it requires an affirmative election to be utilized.
Rules are provided to determine Connecticut taxable income (under both methods) as well as how to handle tiered passthrough entity situations. Under the new entity-level taxing regime, PE’s that incur losses will be able to carryforward those losses to offset future taxable income, until they are fully utilized. In addition, the new law introduces the concept of an elective commonly-owned (based on 80% voting control) PE combined return; for instance, PE1 with a net loss may be combined with related PE2 with net income, to reduce PE2’s tax liability.
Estimated Tax Payment Requirements: Unlike the prior PE taxation regime (whereby the PE paid an annual Connecticut income tax on behalf of its nonresident owners; generally regarded as a distribution), PEs will now be required to make sufficient quarterly estimated tax payments, with respect to the entity level tax, or be subject to an interest penalty for underpayment. For calendar-year PEs (i.e., with a tax year beginning January 1, 2018), under the current legislation, the first 2018 estimated tax payment is scheduled to be due on June 15, 2018.
Therefore, PEs affected by the new legislation must understand the new tax quickly in order to comply with their estimated tax payment requirements for 2018. However, PE owners should generally not have to make estimated tax payments to cover their Connecticut income tax on the PE’s passthrough taxable income but will, at the very least, have to continue to make estimated tax payments to cover their Connecticut income tax on non-passthrough Connecticut taxable income.
Due to these changes, it is likely that the computation of a PE’s taxable income, reporting and payment requirements (i.e., tax compliance burden) will be more complex than under the prior taxing regime. In addition, an owner’s Connecticut income tax compliance will be similarly complicated by the new taxing regime as the owner of a PE subject to the PE tax will now need to consider the Connecticut PE tax credit—with respect to the passthrough income—that can be utilized to offset the owner’s Connecticut income tax liability. In addition, Connecticut estimated tax payments may still be required to be made by an owner of a PE if the credit does not cover the owner’s tax liability or the owner has non-PE income.
The Connecticut Department of Revenue Services has recently formed an ad-hoc committee to address the new PE income taxation regime and will issue administrative guidance.
As a side note, the state of New York, on the heels of the Connecticut PE tax, is now looking into applying a new business income tax on partnerships doing business in New York state, with a corresponding credit for individual and corporate partners of those partnerships. Draft tax legislation has been issued that would impose an unincorporated business tax (“UBT”) and a corresponding owner tax credit. Although the UBT is similar in concept to Connecticut’s PE tax, there are significant differences in its mechanics and design.
New York did, however, move forward to enact an elective Employer Compensation Expense Tax (“ECET”) to circumvent the $10,000 federal itemized deduction limitation on state and local income tax imposed on wages. Connecticut looked at a similar type of payroll tax, but for now, it has been shelved. Under this tax, employers that opt-in will pay a tax on all annual payroll expenses in excess of $40,000 per employee. The ECET is phased in over three years at a rate of 1.5% (2019), 2% (2020) and 5% (2021) beginning on January 1, 2019 (i.e., the tax does not apply in 2018). A tax credit equal to the value of the ECET will be able to be utilized to reduce the personal income tax on the employees’ wages. The employer must make an election to opt into the tax in 2018 for 2019.
Bonus Depreciation and Section 179 Expensing: In addition to the PE income taxation change, Connecticut has retroactively decoupled from federal bonus deprecation and prospectively decoupled from §179 expensing.
For purposes of the personal income tax, applicable to taxable years beginning on or after January 1, 2017 and with respect to “property placed in service after September 27, 2017,” §168(k) bonus depreciation that is deducted for federal income tax purposes is required to be added back. The disallowed depreciation is then deducted equally over the four succeeding tax years (i.e., no depreciation is allowed during the year of acquisition and 25% is deducted over the succeeding 4 years). Due to the retroactivity of the decoupling, PEs and their non-corporate owners who have already filed their 2017 Connecticut income tax return claiming such bonus deprecation will be required to file amended returns to be in accordance with the tax law. For corporation business tax purposes, bonus depreciation continues to be disallowed and the asset is depreciated under the former Connecticut business tax provisions.
In addition, for taxable years beginning on or after January 1, 2018, Connecticut decouples from §179 expensing for both personal and corporate income tax purposes. However, unlike bonus depreciation decoupling, 20% expensing is allowed in the year of the acquisition and over the next four years.
Federal tax reform has certainly trickled into the state tax area and has added layers of complexity. As discussed above, Connecticut and New York (both high income tax rate states) are proactively addressing the impact of federal tax reform’s state and local tax itemized deduction limitation with respect to owners of passthrough entities and wage earners. On the other hand, states are aware of the monetary impact that federal tax reform will have on their budgets and are enacting laws to decouple from favorable federal tax reform provisions, such as bonus deprecation and §179 expensing.
More to come.
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