Connecticut Tax Laws Respond To Federal Limitation On State And Local Tax Deduction
In legislation passed in the 2018 legislative session, Connecticut has enacted a number of provisions in response to the federal tax legislation that was enacted in December 2017. Below, we will specifically address two provisions intended to respond to the part of that federal tax legislation that caps at $10,000 (per tax return) the amount taxpayers can deduct from federally taxable income with respect to state and local taxes paid: a new pass-through entity tax and a charitable donation credit with respect to certain amounts attributable to property taxes.
New Pass-through Entity Tax
On May 31, 2018, Governor Dannel Malloy signed into law new legislation (Public Act No. 18-49) (the "2018 Tax Act") that will impose a 6.99% Connecticut state tax at the entity level on the Connecticut-source income of pass-through entities (the "New Pass-through Tax"), including entities treated as partnerships for U.S. federal income tax purposes as well as S corporations. The base for calculating this tax is determined under one of two methods: (1) "Connecticut Source Income Method," or (2) "Alternative Tax Base Method." It is expected that the alternative tax base method will likely result in the maximum federal income tax benefit in most situations, although it requires an affirmative election to be utilized.
Pursuant to guidance expected shortly from the Connecticut Department of Revenue Services ("DRS"), amounts paid to partners as guaranteed payments will not be included in the tax base on which the New Pass-through Tax is calculated. Therefore, Connecticut resident partners receiving guaranteed payments from the entities in which they are partners will continue to be required to pay quarterly estimated taxes on the amounts of such guaranteed payments. Non-resident partners receiving guaranteed payments will similarly have an obligation to make payments to DRS of quarterly estimated taxes due with respect to the Connecticut source portion of the guaranteed payments received. In some cases, this may be a new filing for such non-resident partners, if the pass-through entity previously filed the returns and paid such quarterly Connecticut tax on behalf of such non-resident partners but no longer does so under the New Pass-through Tax regime.
The New Pass-through Tax is fully deductible for U.S. federal income tax purposes and is offset by a tax credit at the personal level equal to 93.01% of the pass-through entity's owner's pro rata share of the tax paid by the pass-through entity. This legislation is intended to provide certain Connecticut taxpayers with relief from the $10,000 limitation on the amount of state and local taxes that can be deducted from income for U.S. federal income tax purposes under the federal tax reform legislation that was passed in December 2017, as this limitation applies only to individuals and does not apply to state and local taxes paid directly by entities.
Note that the New Pass-through Tax does not apply to disregarded entities. Therefore, in the case of a sole proprietorship, the sole owner may want to consider adding another nominal partner in order to convert the sole proprietorship from disregarded entity status to partnership status in order to benefit from this new legislation.
With respect to partners who are not resident in Connecticut, if the only Connecticut-source income of such partner is from one or more pass-through entities that each pay the New Pass-through Tax at the entity level, such partners may not be required to file a Connecticut personal income tax return. If, however, a pass-through entity in which a nonresident is a partner does not pay the tax at the entity level (for example, by "recharacterizing" payments made by partners, as further described below) or elects to file a combined return with one or more other pass-through entities, and the credit(s) that would be received by the nonresident partner are not sufficient to fully satisfy such partner's Connecticut income tax liability, then such partner will still be required to file a Connecticut personal income tax return.
This aspect of the 2018 Tax Act is effective retroactively to January 1, 2018, which means that a pass-through entity is required to make estimated payments against its pass-through entity tax liability beginning with the June 15 deadline for calendar year taxpayers. Estimated payments for calendar year filers are due on April 15, 2018, June 15, 2018, September 15, 2018, and January 15, 2019. The law generally requires that each estimated payment equal 22.5% of the pass-through entity's tax liability. Recognizing that this tax was enacted after the April 15, 2018 deadline, the DRS offers a few options for entities to comply with their 2018 estimated payment requirements:
Making a catch-up payment in June that covers amounts due in both April and June;
Making three payments of 22.5% of the 2018 liability in June, September and January 2019, with the full amount of tax due by the return due date;
Annualizing the estimated payments for the year; or
Recharacterizing all or a portion of any April, June, or September 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.
If opting to recharacterize payments made by partners, 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.
Many aspects of the New Pass-through Tax remain unclear, including further details regarding how it will work for partners that are not Connecticut taxpayers (whom, therefore, may not be able to claim a full credit for the new tax). Further guidance on these and other open points has been requested from DRS and should be forthcoming.
Charitable Donation Credit for Certain Amounts Attributable to Property Taxes
The 2018 Tax Act also enacts a new provision of Connecticut state tax law that would permit a municipality within the state to provide a residential property tax credit for the following year, provided such credit would not exceed the lesser of (A) the amount of property tax owed or (B) 85% of the amount of voluntary, unrestricted and irrevocable cash donations made by or on behalf of the owner of a residential property located in the municipality to a "community supporting organization" during the calendar year preceding the year in which an application for such tax credit is filed. A community supporting organization is defined to mean an organization that is tax-exempt under section 501(c)(3) of the Internal Revenue Code of 1986, as amended, and which is organized solely to support municipal expenditures for public programs and services, including public education.
Effective July 1, 2018, this aspect of the 2018 Tax Act would permit taxpayers to effectively redirect amounts that would have been classified as property taxes, federal deductions of which are subject to the $10,000 cap on state and local taxes paid, as charitable donations, which are not subject to such cap.
Will These New Provisions Work for Federal Purposes?
On May 23, 2018, the IRS issued Notice 2018-54 (the "Notice") addressing the property tax credit regime described above. The Notice says that the IRS and Treasury Department intend to propose regulations that will address the federal income tax treatment of certain payments made by taxpayers for which taxpayers receive a credit against their state and local taxes. The Notice specifically states that such proposed regulations will be a response to certain state legislatures that "are considering or have adopted legislative proposals that would allow taxpayers to make transfers to funds controlled by state or local governments, or other transferees specified by the state, in exchange for credits against the state or local taxes that the taxpayer is required to pay." In addition to Connecticut, similar proposals have been enacted or are being considered in New York, New Jersey and Oregon, among other states.
According to the Notice, "despite these state efforts to circumvent the new statutory limitation on state and local tax deductions, taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purposes."
Therefore, it is clear that the IRS and Treasury Department are aware of the property tax credit regime enacted in the 2018 Tax Act and do not believe that it works for federal purposes. However, it is not clear how a challenge to this position would be decided.
With respect to the new pass-through entity tax, the tax itself is imposed at the state level and is currently required to be paid by law. Further, it seems clear that, under current law, the $10,000 limitation on federal deductions for state and local taxes paid is intended to apply only to individuals and not to entities. Therefore, this aspect of the 2018 Tax Act is expected to be more difficult to challenge at the federal level. However, complications may arise with respect to the tax credit piece of this new provision, since not all states will provide a credit. Further, even if the new pass-through entity tax technically works, some question whether it is sound tax policy to implement a regime clearly intended to result in a different outcome than the one that would otherwise occur under current federal tax law.
Ultimately, there is a significant lack of certainty regarding whether and how various aspects of the 2018 Tax Act will be implemented.