On May 31, 2018, Governor Malloy signed P.A. 18-49, which fundamentally changes how income earned by pass through entities such as S corporations, partnerships, and multi-member LLCs are taxed. The new legislation does not affect the taxation of publicly traded partnerships, sole proprietorships, or single member LLCs.
The legislation is retroactively effective to January 1, 2018. For tax years beginning on or after that date, a pass-through entity is now subject to tax, at a rate of 6.99%, on its own income. The new law provides a tax credit that partners may claim on their Connecticut income tax return, intended, generally, to ensure that the pass-through entity’s income is not taxed twice.
The policy goal of the legislation is fairly novel. It is intended as a revenue-neutral work around to the $10,000 limitation to the deduction for state and local taxes contained in the revisions to the federal tax law. The new Connecticut tax law transfers the Connecticut income tax deduction from the business owners to the entity itself. Because the new state tax will be an expense of the pass-through entity that pays it, the tax reduces the federal taxable income of the individual owners of pass-through entities, it offsets, at least in part, the effects of the federal law’s new limitation on the deduction for state and local taxes. Each such owner is now provided a refundable credit against the Connecticut personal income tax in an amount equal to 93.01% of that owner’s pro rata share of the tax paid by the pass-through entity. An individual owner who is either a full year or part year resident of Connecticut is also entitled to a credit against the Connecticut personal income tax for that individual’s pro rata share of taxes paid to another state or the District of Columbia on income of the pass-through business entity if the Commissioner of Revenue Services determines that the tax is substantially similar to the new Connecticut pass through entity tax.
A nonresident individual whose only Connecticut source income is from one or more Connecticut pass-through entities which entities pay the pass-through entity tax will not need to file a Connecticut personal income tax return. However, an individual member of a pass-through entity that has elected to file a “combined return” with one or more other pass through entities and pass-through chooses to file a combined return and the offsetting credit for the pass-through’s tax payment does not completely satisfy the nonresident’s Connecticut personal income tax liability.
Because the new Connecticut tax law is made retroactive to the beginning of 2018 and requires pass-through entities to make estimated tax payments quarterly (i.e. April 15, June 15, and September 15 of 2018, and January 15 of 2019), the affected entities are, in effect already late on the first payment due. The Department of Revenue Services has stated that entities may make solve this issue in any of three ways:
- Make a catch-up payment with the June 15, 2018 estimated payment that satisfies both the first and second estimated payment requirements;
- Make three estimated payments (by each of June 15 and September 15 in 2018, and by January 15 in 2019) each equaling 22.5% of the total tax liability, with the final payment due with the tax return; or
- Annualize their estimated payments for the taxable year
Further, DRS will allow pass-through entities to recharacterize all or a portion of any April 15, 2018, June 15, 2018, or September 15, 2018, income tax estimated payments made by any of their individual partners, with such partner’s consent, so that the payments are applied against the pass-through entity’s 2018 estimated payment requirements. The recharacterization of these 2018 income tax estimated payments must be completed by December 31, 2018. The recharacterized amount will be deemed to have been made by the pass-through entity on the date that the individual partner remitted the estimated payment to DRS. DRS will provide information by September 30, 2018, about the mechanism to re-characterize these estimated payments.
A pass-through entity may make its June 15, 2018 estimated tax payment by completing an estimated tax payment coupon and mailing it to DRS with a check. The estimated tax payment coupon may be downloaded here. For the September 15, 2018 estimated payment, a pass-through entity may also make its estimated payment at http://www.ct.gov/tsc.
Because individual partners will get a credit for the Pass-Through Entity Tax paid by their pass-through entity, many resident individual and trust partners will no longer need to make estimated income tax payments to cover their Connecticut income tax liability arising from their pass-through entity income. A partner may still be required to make estimated income tax payments depending upon the method the pass-through entity uses to calculate the Pass-Through Entity Tax, if the partner has income from other sources, or if the individual partner is an employee who will not have enough income tax withheld from their wages. Partners should consult with their pass-through entities and tax counsel to determine how they will be affected.
DRS has stated it is aware that some individual partners have already remitted the first-quarter estimated income tax payment and may have scheduled the automatic payment of the second, third and fourth quarter estimated income tax payments. If an individual partner determines that he or she no longer needs to make estimated income tax payments, the partner may cancel any pending scheduled payments.
In circumstances where partners or other owners of affected pass through entities have already made estimated individual income tax payments, there are two options:
- The individual partners (or other owners) will receive a refund when they file their 2018 Connecticut returns; or
- The individual partners may have all or a portion of their 2018 income tax estimated payments re-characterized so that the payments are applied against their pass-through entity’s 2018 estimated payment requirements. This must be done by December 31, 2018.
The new law provides for a taxpayer to elect either of two methods of calculating the tax:
- Multiply the applicable rate by the entity’s Connecticut source income; or
- If timely elected, the taxpayer may apply the rate to an “alternative tax base” that is equal to the “resident portion of unsourced income” plus “modified Connecticut source income.”
Some definitions will help here.
Unsourced income generally equals the business’s net income as calculated for federal tax purposes, increased or decreased by applicable personal tax deductions and without regard to the location from which the items of income and adjustments are derived, minus the business’s Connecticut sourced income without any adjustments for tiered business entities and also minus the business’s net income, for federal tax purposes, that is derived from sources in another state with jurisdiction to tax the entity, as increased or decreased by any adjustments that apply under the personal income tax that are derived from, or connected to, sources in another state with jurisdiction to tax the entity.
Modified Connecticut source income is defined as the business’s Connecticut source income multiplied by a percentage equal to the sum of ownership interests in the business that are owned by individual members that are (i) subject to the Connecticut personal income tax or (ii) pass-through businesses subject to the entity tax to the extent that such businesses are directly or indirectly owned by individuals subject to the Connecticut personal income tax.
The resident portion of unsourced income is “unsourced income” multiplied by a percentage equal to the portion of the ownership interests in the business entity owned by individual members who are Connecticut residents.
While there is not yet published guidance, election of the alternative tax base seems likely to be more attractive to Connecticut residents because it increases the available tax credit to include “unsourced income” as well as Connecticut sourced income. This alternative tax calculation should also permit a business to avoid paying the pass-through entity tax to the extend of income earned by owners who are not subject to the Connecticut personal income tax, such as Subchapter C corporations and tax-exempt entities.
Partners in a pass-through entity that files on a fiscal year basis appear to need to continue to make 2018 estimated income tax payments. If a pass-through entity is a fiscal year filer, the distributive share of the entity’s income from its 2018 return will be included in such partner’s 2019 income tax return. Hence, the credit associated with the entity’s 2018 return will not be claimed until the partner’s 2019 Connecticut income tax return is filed.
We are still awaiting guidance on some issues that remain unresolved with the new law, such as:
(i) The impact on nonresident owners who reside in jurisdictions with an income tax that
may not grant a credit for the new Connecticut tax;
(ii) The applicability of the tax to guaranteed payments; and
(iii) The impact of the Connecticut modification from federal adjusted gross income for
Connecticut taxes. In addition, any sole proprietorship operated as a single member
limited liability company treated for federal tax purposes as a disregarded entity,
should consult with a tax advisor as to whether the owner should convert to
pass-through status by adding a nominal partner to take advantage of the tax benefit
afforded by this legislation.
This information is provided as a review of general principles only and is not intended as legal or tax advice. The reader is cautioned to discuss his or her specific circumstance with a qualified practitioner before taking any action.