Connecticut Reacts to Federal Tax Law Reform Changes
The sweeping changes created by the federal Tax Cuts and Jobs Act ("TCJA") has resulted in some states enacting their own legislation in response to the federal tax reform. On May 31, 2018, Connecticut signed into law a bill known as, "An Act Concerning Connecticut's Response To Federal Tax Reform" (the "Act"). Although the Act makes several changes to Connecticut's tax regime, this Alert highlights only a few areas of interest. Specifically, this Alert discusses certain provisions of the Act that seek to mitigate the new federal limitation on state income and property tax deductions for individuals who itemize. As discussed below, the Act creates two mechanisms to try and work around this new federal limitation. First, the Act imposes a revenue-neutral state tax on pass through entities ("PTEs") which consist of sole proprietorships, general and limited partnerships, limited liability companies taxed as partnerships, and S corporations, by assessing a tax on the entity itself. Although a tax is imposed on the entity, the Act also provides for a corresponding tax credit for the owner with the intent that the entity is able to reduce its federal taxable income (that is ultimately passed through to its owners) by being able to take a state tax deduction. In addition, the Act creates a residential property tax credit for an individual who makes a voluntary payment to a municipally-approved "community supporting organization" thereby, allowing that individual (if he/she itemizes) to claim a federal income tax deduction in the form of a charitable contribution.
The Act imposes a new 6.99% income tax on a PTE with a corresponding offsetting credit for the PTE's owners. The idea is that this tax would be revenue-neutral by shifting the non-deductible individual income tax to a deductible business tax on PTEs. Under TCJA there is no limitation on state and local taxes that are directly imposed on business entities and thus, the taxable income allocated to the business owner would be reduced by the PTE tax assessed against the business.
The new PTE tax would be calculated based on either the entity's taxable income, as determined for federal income tax purposes, that is derived from Connecticut sources (Connecticut-source income), or, at the election of the PTE, based on an alternative tax base.
Pursuant to the Act, PTE tax returns will replace PTE composite returns and payments. The PTE is required to pay the tax on or before the 15th day of the third month following the close of its taxable year and to report to the entity's owners their share of the entity's tax. In addition, nonresident individuals would not be required to file a Connecticut personal income tax return if their only income for the tax year derives from PTEs that are paying the PTE tax. However, a nonresident individual is required to file Connecticut personal income tax return if the PTE that it is a member of has elected to file a combined return with one or more other PTEs and the Connecticut tax liability of the nonresident individual is not fully satisfied.
For tiered pass-through structures, the Act requires PTEs to adjust their income to account for instances where one business is a member of another business. Specifically, if a lower-tier entity is a member of another pass-through business (an upper-tier entity), then the lower-tier entity must subtract or add, as applicable, its distributive share of the upper tier entity's loss or income from Connecticut sources when calculating its taxable income.
The alternative tax base is defined as the sum of a PTE's "modified Connecticut-source income" plus its "resident portion of unsourced income." A PTE's "modified Connecticut-source income" equals its Connecticut-source income multiplied by a percentage equal to the sum of ownership interests in the entity held by members that are: (1) subject to personal income tax, or (2) PTEs subject to the entity tax, to the extent the PTEs are owned by individuals subject to the income tax. A PTE's "resident portion of unsourced income" is calculated by multiplying "unsourced income" by a percentage equal to the sum of the ownership interest in the PTE that belongs to Connecticut residents. "Unsourced income" equals: (1) the PTE's net income for federal income tax purposes, plus or minus state modifications; minus (2) the PTE's Connecticut-sourced income (without any adjustments for tiered entities); minus (3) the PTE's net federal income that is derived from or connected to sources in another state with jurisdiction to tax the PTE, plus or minus state modifications.
The Act requires each PTE to make estimated tax payments in a manner similar to the Connecticut personal income tax as follows:
- 25% by the 15th day of the 4th month of the tax year;
- 25% by the 15th day of the 6th month of the tax year;
- 25% by the 15th day of the 9th month of the tax year; and
- 25% by January 15 of the next tax year.
The Act allows PTEs to use the annualized income installment method to compute estimated tax liability if it results in a lower installment payment.
The estimated tax payments are effective for 2018 and as such a PTE can comply with its 2018 estimated tax payment requirements by: (1) making a catch-up payment with its June 15, 2018 estimated payment that is sufficient to satisfy both the first and second estimated tax payment requirements; (2) making three estimated payments (on or before each of June 15, 2018, September 15, 2018, and January 15, 2019) each equal to 22.5% of the tax liability (with the full amount of tax remaining due by the return due date); or (iii) annualizing its estimated payments for the taxable year.
The new PTE tax would be offset by a Connecticut income tax credit distributed to PTE owners. The credit equals the PTE owner's distributive share of the PTE tax paid by the PTE multiplied by 93.01%. The Act also authorizes a personal income tax credit for members of the PTE that have paid taxes to other states, or the District of Columbia, that are substantially similar to the PTE tax. For Connecticut personal income tax purposes, this would be a refundable tax credit. For corporate PTE owners, any amount of credit exceeding the corporation's Connecticut corporate tax liability would be carried forward to future tax years.
Property Tax Credit/Charitable Contribution Deduction
Effective July 1, 2018, under the Act, Connecticut municipalities are allowed to provide for a residential property tax credit not to exceed the amount of voluntary cash donations made by the owner of a residential property located in the municipality to a "community supporting organization" during the preceding tax year. The provision is intended to give municipalities revenues towards community services while at the same time theoretically allowing individuals who itemize the ability to claim a federal state and local tax deduction in the form of a charitable contribution.
Under the Act, a "community supporting organization" means an organization that is: (A) exempt from taxation under IRC Section 501(c)(3), and (B) organized solely to support municipal expenditures for public programs and services, including public education. The tax credit authorized by a municipality may not exceed the lesser of either: (1) the amount of property tax owed, or (2) 85% of the taxpayer's donations. To claim the property tax credit, a taxpayer would have to submit an application to the tax collector in the municipality in which the property is located, between January 1 and April 1 of the fiscal year preceding the fiscal year for which the taxpayer will claim the credit. The application would have to evidence the amount of the taxpayer's donations. The taxpayer would also have to submit an affidavit affirming that the donations were made in cash and were voluntary, unrestricted, and irrevocable. Further, a taxpayer would not be allowed to use the donations to claim a tax credit for more than one assessment year.
The sustainability of the two deduction workarounds in the Act (i.e., the PTE tax with a corresponding Connecticut personal income tax credit and the charitable deductions to a community supporting organization) depend in part on the IRS's application of these provisions under the federal income tax law. Variations of the charitable deduction workaround have been proposed or enacted in other jurisdictions with the expectation that many states will enact creative laws to counteract some of the new federally imposed limitations created by TCJA.
This communication is intended for general information purposes and as a service to clients and friends of Verrill Dana, LLP. This publication, which may be considered advertising under the ethical rules of certain jurisdictions, should not be construed as legal advice or a legal opinion on any specific facts or circumstances, nor does it create attorney-client privilege.