Like many states, Connecticut is wrestling with how the Tax Cuts and Jobs Act's ("TCJA") $10,000 limitation on a taxpayer's ability to deduct state and local taxes on their federal returns will impact its residents. Governor of Connecticut, Daniel Malloy recently announced that the TCJA's ceiling on state and local tax deductions would result in a loss of approximately $10 billion of deductions for Connecticut taxpayers. This would be absent of any change at the state level. To that end, Governor Malloy is requesting legislation that targets the cap in an attempt to relieve the state's taxpayers.
Key Details on the Pass-Through Entity Tax Reform
The main element of the Connecticut Plan is that it calls for a tax of 6.99 percent on the net receipts of partnerships, S corporations and limited liability companies treated as partnerships for federal income tax purposes. Since the tax would be incurred during the course of carrying on a trade or business, it could be claimed as a business expense — thus a deduction at the federal tax level. Seemingly, the new entity level tax would lower the pass-through entity’s distribution to its partners, shareholders or members. While a new state income tax credit would offset 100 percent of the tax, such taxpayers would normally pay on their share of the pass-through income.
Connecticut officials estimate that the pass-through entity tax would preserve about $600 million of the SALT deductions that would otherwise be lost by state residents under the constraints of the TCJA. While a number of jurisdictions impose some form of tax on pass-through entities, Governor Malloy includes the dollar for dollar personal income tax credit available for partners, members and S-corporation shareholders with respect to the tax paid at the entity level.
Inherent Issues with Connecticut’s Plan
Whether Connecticut’s proposed change to its taxing scheme is ultimately enacted remains to be seen; however, it’s important to explore all aspects of the proposal:
- Governor Malloy’s proposal would provide a benefit only to owners of pass-through entities;
- Many of the owners would also benefit from the TCJA’s special 20 percent deduction with respect to such entities;
- The entity based tax does not assist residents whose principal income comes in the form of wages; and
- While the tax might encourage pass-through entities to locate in Connecticut, its perks would be aimed at high-income residents. These high-earning residents would generally benefit the most from state efforts to avoid the TCJA’s SALT deduction cap.
The reversal of the normal taxing regime, taxing the entity and not the individual, raises many questions. Perhaps the most problematic questions are how will out-of-state business owners be treated? Is it possible that the business will be subject to tax in Connecticut, while the individual faces taxation in their home state without the aid of a tax credit?
If you have any questions about Connecticut’s proposed plan, please contact the author at email@example.com, or your Friedman LLP tax advisor.