When President Trump signed into law the Tax Cuts and Jobs Act (Tax Reform Act) late last year, one of the provisions disallowed the itemized deduction for state and local taxes more than $10,000. By limiting this deduction, owners of Connecticut businesses operating in the pass-through entity form (i.e., sole proprietorships, partnerships, limited liability companies, and S corporations) stood to see their federal income taxes rise, irrespective that their marginal federal tax rate may decrease.
Currently, Connecticut does not impose an entity level tax on the income earned by a pass-through entity; rather, the income “passes through” to the individual owners and is subject to federal and Connecticut income taxation at the individual level. Paying the state income tax, individual owners can claim an itemized state income tax deduction on Schedule A of Form 1040 to reduce passed-through income. For tax years beginning on or after January 1, 2018, if the amount of this tax, property taxes, taxes withheld from wages, and other taxes paid exceed $10,000, that excess is no longer deductible, thus creating an increase in federal taxable income subject to taxation.
To mitigate the impact of the “lost” federal state deduction attributable to income earned by owners of Connecticut businesses operating as passthrough entities, Governor Dannel P. Malloy recently proposed in his 2019 fiscal year budget an “end-around” to this lost deduction.
The governor proposes a revenue-neutral state tax on passthrough entities and their owners that would theoretically eliminate the cap on the state tax deduction for federal income tax purposes. Under this proposal, Connecticut would shift the non-deductible individual income tax to a deductible business tax on passthrough businesses (under the Tax Reform Act, there is no limitation on state and local taxes that are directly imposed on business entities) and would allow a credit for the entity-level tax to the owners of the businesses against their Connecticut personal income taxes.
As an example, a pass-through entity with one resident owner in the highest federal and Connecticut income tax brackets which generates $100,000 of taxable income would be required to pay $6,990 of Connecticut income taxes. For federal income tax purposes, the owner’s federal taxable income would be $93,010 (the same as it would have been prior to the new law)-providing a federal income tax savings of roughly $2,500. But Connecticut would again impose the individual income tax on the owner’s pass-through income, as it did before, and as such it would be double-taxed. To mitigate that double taxation, the governor’s proposal would provide a tax credit to the owner to neutralize the aggregate tax imposition.
Interestingly, the governor has not proposed coupling with the new federal 20% federal income deduction allowed against an owner’s passthrough income (i.e., the new Section 199A deduction). Currently, Connecticut individuals are subject to income taxation based on their federal adjusted gross income (AGI) plus or minus certain state income modifications. Since the 20% deduction is a deduction against a taxpayer’s federal taxable income and not a deduction to arrive at adjusted gross income, Connecticut taxpayers miss out on the deduction. Connecticut’s legislators would need to pass a law to obtain this deduction, though considering Connecticut’s fiscal affairs, that seems unlikely.
During this legislative session, the General Assembly will meet to address the passthrough entity tax proposal as well as address the impact that the Tax Reform Act will have on all Connecticut taxpayers. It is expected that reactionary tax legislation will be forthcoming to address the revised Internal Revenue Code, and the proposal addressing the impact of the lost state income tax deduction will likely be considered. There will be a lot to watch over the next three months before the Connecticut General Assembly adjourns in early May 2018.
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