The Tax Cuts and Jobs Act placed a $10,000 cap on individual state and local tax deductions. As a result, many states, particularly those with higher state income tax rates, have been working to pass new legislation and implement new measures to offset the federal tax deduction limitation.
The State of Connecticut passed a new law in May of this year enacting a new nonvoluntary tax on all passthrough entities doing business in the state. This new tax is effective for periods beginning on or after January 1, 2018, and will have an impact on returns for the upcoming tax season. So a taxpayer with a fiscal year end of June 30, 2018, would file its first passthrough tax return for the period of July 1, 2018 – June 30, 2019.
Shifting Tax to Passthroughs
Generally, passthrough entities do not pay tax, that’s how the name passthrough was originated. But, this new Connecticut passthrough tax is imposed at the passthrough level on partnerships, limited liability companies and S corporations that do business in Connecticut or have income from Connecticut sources. The idea behind the creation of this new law was the desire to move the payment of state income tax, otherwise paid by an individual who is now limited on the ability to deduct the tax, to the passthrough entity that generates the revenue that would have been taxed to the individual, as the passthrough entity can still deduct the full amount of state income tax under federal law.
How It Will Work
The new passthrough tax can be calculated one of two ways: a standard base calculation or an alternative base calculation. And, both methods tax the passthrough entity on the income that would have been taxed to Connecticut individual taxpayers under the previous law. The non-resident members can still claim the credit if they want a refund. We just don’t know if other states will provide a deduction for the Connecticut passthrough credit or not. That will be decided on a state-by-state basis.
Corporate and individual partners also receive an off-setting passthrough entity credit. Unused credits can be carried forward by corporations and is refundable to individuals.
Uncertainty Going Forward
There are still many questions about this new law that remain unanswered. And, as with other such work-around state laws that have been introduced to offset the limitation on the individual deduction of state taxes, it is likely the U.S. Treasury Department and the IRS will be providing comment related to denying federal deductions that the passthrough entity will claim for the new Connecticut passthrough tax.
Take a deeper dive into this Insight’s subject matter.State & Local Tax (SALT)