Connecticut Enacts Pass-Through Entity Tax and Other Responses to Federal Tax Reform
Connecticut Enacts Pass-Through Entity Tax and Other Responses to Federal Tax Reform
On April 27, 2018, Connecticut Governor Dannel Malloy signed S.B. 11 (Public Act 18-2) to enact legislation that responds to the Tax Cuts and Jobs Act (the “TCJA”). The new law imposes an income tax on pass-through entities (PTEs) effective for tax years beginning on or after January 1, 2018, in response to the TCJA’s $10,000 limitation on the “SALT deduction.” In addition, S.B. 11 authorizes Connecticut municipalities to provide residential property tax credits for donations to “community supporting organizations.” S.B. 11 also imposes new modification adjustments with respect to federal 100-percent bonus depreciation, Internal Revenue Code (IRC) section 179 expensing, and a new five-percent expense disallowance provision with respect to the Connecticut dividends received deduction (DRD).
Connecticut joins New York State in enacting “workarounds” to the TCJA’s capping of the state and local tax deduction at $10,000. In addition, Connecticut is the latest of a number of states to respond to some of the other TCJA provisions.
Pass-Through Entity Tax
The new PTE tax imposed by Connecticut will apply to S corporations, partnerships, and limited liability companies (LLCs) treated as partnerships for federal income tax purposes. However, it will not apply to publicly traded partnerships that agree to file an annual Connecticut partnership return and report certain information of unitholders with more than $500 in distributive income from Connecticut sources. The PTE tax will be imposed at a rate of 6.99 percent on either the PTE’s taxable income (federal net income under IRC section 702, as modified by Connecticut addition and subtraction adjustments) or alternative tax base. The modification adjustments are those applied for Connecticut personal income tax purposes and the PTE must also use the personal income tax sourcing rules, not the corporate income tax single sales factor apportionment formula. The “resident portion of unsourced income” equals the PTE’s “unsourced income” multiplied by a ratio equal to the sum of PTE ownership interests held by Connecticut resident over total interests. “Unsourced income,” in turn, is generally the PTE’s total federal net income, as modified by Connecticut adjustments, less income from Connecticut sources and income sourced to other states that impose tax on the PTE. To the extent a PTE has a net loss, it can carry forward the net loss indefinitely.
The “workaround” to the new federal “SALT deduction” cap is a tax credit provided to S corporation shareholders, partners, and LLC members for Connecticut corporation business tax, personal income tax, as well as income taxes paid to another state or the District of Columbia. It is a refundable credit equal to the shareholder’s, partner’s, or member’s proportional share of the PTE tax paid by the PTE, which is multiplied by 93.01 percent.
With respect to reporting, PTE tax returns will replace PTE composite returns and payments, and the filing deadline will change from April 15 to March 15 each year. For tax years beginning on or after January 1, 2018, S.B. 11 eliminates the requirement for a PTE to file a composite return and pay tax on behalf of nonresident owners. In addition, if a nonresident owner’s only source of Connecticut income is from a PTE that pays the PTE tax, the nonresident owner is not required to file a Connecticut tax return (unless the PTE chooses to file a combined return and the offsetting credit for the PTE’s tax payment does not completely satisfy the nonresident’s Connecticut personal income tax liability).
The legislation also provides rules for tiered PTE structures, computation of the Connecticut alternative tax base, combined reporting elections for commonly owned PTEs, requirements for PTE annual reports to owners, quarterly estimated tax payment requirements for PTEs, and penalty, interest, collection and enforcement provisions.
Residential Property Tax Credit
Effective July 1, 2018, S.B. 11 also authorizes Connecticut municipalities to provide a residential property tax credit for irrevocable, “voluntary” cash donations to “community supporting organizations” (i.e., IRC section 501(c)(3) tax-exempt organizations) located in the municipality. The amount of residential property tax credit will be equal to the lesser of the property tax owed or 85 percent of the donation amount.
Other Responses to Federal Tax Reform
For qualified property placed in service after September 27, 2017, and before January 1, 2023, IRC section 168(k) provides for 100-percent federal bonus depreciation as a result of the TCJA. Retroactive to tax years beginning on or after January 1, 2017, S.B. 11 requires an individual to add-back to Connecticut adjusted gross income the entire amount of an individual’s federal bonus depreciation deduction. The individual will be provided a subtraction modification adjustment of 25 percent of the amount added back in each of the following four tax years. Connecticut already decoupled from federal bonus depreciation for corporation business tax purposes prior to the enactment of the TCJA.
With respect to certain trade or business property, IRC section 179 provides taxpayers an election to expense the asset in the year acquired, rather than depreciate. The TCJA increased the dollar and investment limits to $1 million and $2.5 million, respectively. Effective for tax years beginning on and after January 1, 2018, S.B. 11 requires an addition modification adjustment by corporations and individuals for 80 percent of their federal IRC section 179 deduction. Corporations and individuals will then be allowed a subtraction modification adjustment for 25 percent of the amount added back in each of the following four tax years.
S.B. 11 will also decouple from the business interest limitation provisions set forth in IRC section 163(j) and will provide a subtraction modification for amounts included in federal gross income under amended IRC section 118(b)(2) (pertaining to incentive contributions and grants made by state and local governments to corporations that are now includible in federal gross income).
Like a number of states, Connecticut requires the add-back of expenses attributable to dividends that are eligible for deduction under Connecticut’s DRD. To simplify such expense disallowance, S.B. 11 enacts an arbitrary expense disallowance provision. Effective retroactively for tax years beginning on and after January 1, 2017, nondeductible expenses will equal five percent of all dividends received by a corporation during the tax year. A corporation must also apportion those expenses if it conducts business in and outside Connecticut. A corporation will be allowed to petition for an alternate percentage if it believes the dividend expenses that were incurred during the tax year and previous tax years are less than five percent of dividends received. A taxpayer will be required to submit the petition within 60 days of the original due of its corporation business tax return, and establish by clear and convincing evidence that its proposed alternative expense amount accurately reflects expenses related to dividends received.
In Office of Commissioner Guidance, OCG-4 (issued April 6, 2018), re-issued April 30, 2018), the Department of Revenue Services (DRS) indicated that IRC section 965(a) deemed repatriation income amounts would qualify for the Connecticut DRD; however, the DRS also indicated that 10 percent of the IRC section 965(a) amount represented the expense disallowance amount. The guidance in OCG-4 was re-issued on April 30, 2018, to provide for the five percent expense disallowance amount.
- Connecticut’s PTE tax will impact PTEs, as well as Connecticut resident and non-resident owners, and is likely to have other tax consequences that may not be fully appreciated by the Connecticut legislature or other proponents of the measure.
- There are questions regarding the viability of Connecticut’s residential property tax credit for cash donations to community supporting organizations and whether the donations will qualify as charitable contribution deductions for federal income tax purposes.
- Corporate taxpayers affected by S.B. 11, including the adjustments for IRC section 179 expensing and the Connecticut DRD 5 percent expense disallowance provision, should consult with their financial statement auditor and tax advisor to evaluate and determine the potential financial statement implications under ASC 740, including the impact on current and deferred taxes, uncertain tax benefits, and disclosures.