On May 31, 2018, Connecticut Governor Dannel Malloy signed into law Public Act No. 18-49, “An Act Concerning Connecticut’s Response to Federal Tax Reform” (the Act), making its purpose clear. A direct reaction to the federal Tax Cuts and Jobs Act (TCJA), the Act has broad effect on individual and business taxpayers and became effective upon its signing. Most provisions impact tax years commencing on or after January 1, 2018.
Major changes include:
Pass-Through Entity Tax (PET)
While new taxes are generally taxpayer friendly, the PET is designed to be revenue neutral to the State and taxpayers alike. With the TCJA limiting the deductibility of state and local taxes paid by individuals to $10,000, pass-through entities (PTE) with Connecticut source income are required to pay a tax on that income at a rate of 6.99% — the highest individual tax rate. To work around this, under the Act, members of the PTE will receive a credit on their Connecticut personal income tax return equal to their pro rata share of entity income multiplied by 93.01%.
Illustrating the Basics
AB partnership is owned equally by A, a Connecticut resident, and B, a nonresident. The partnership earns $1,000,000 before taxes in 2018, all Connecticut source. AB will pay a PET of $69,900 (1,000,000 * 6.99%). A and B will each have $465,050 of income from AB (($1,000,000 - $69,900)/2).
Assuming A has no other source of income, he will report the $465,050 on his Connecticut personal income tax return. His tax liability (assuming the top rate and no other deductions) will be $32,507 ($465,050 * 6.99%).
A will receive a tax credit of $32,507 ($69,900/2*93.01%) for the PET paid by AB. His additional balance due will be zero. B, as a nonresident, with no additional Connecticut source income, is not required to file.
The Upshot: By shifting the personal income tax liability to the PTE, the State has designed a revenue neutral tax for the entity and the individual owners, while preserving the state tax deduction by reporting a lower federal taxable income through the deduction of the PET. Whether this workaround will stand up to federal scrutiny is uncertain.
Changes to Filing Requirements and Estimated Payments: The PET replaces the former composite tax the PTE was required to pay for nonresident members. However, unlike the composite tax, the PET requires the entity to make four equal installment payments. Recognizing that the PET was not enacted until May 31, 2018, the Department of Revenue Services (DRS) will permit a PTE to make catch-up payments. Additionally, any estimated payments made by any individual partner of the PTE can be partially or fully recharacterized as a payment by the entity. The election must be made by each individual partner by December 31, 2018.
Other Important Changes in Response to the TCJA
Bonus Depreciation: Effective for tax years beginning in 2017, the State has decoupled from the new federal bonus depreciation. Taxpayers who have already filed for 2017 and taken bonus depreciation are required to amend their Connecticut returns. Individual taxpayers will be permitted to deduct the federal bonus depreciation 25% per year in the four subsequent tax years. For the corporate tax, bonus depreciation has been disallowed in full.
Section 179 Expensing of Assets: 80% of deductions permitted by the TCJA will be eliminated for both individual and corporate taxpayers. However, the disallowed portion will be deductible in equal amounts over the four succeeding years.
Corporation Business Tax (CBT) Dividends Received Deduction: The TCJA required certain taxpayers with untaxed foreign earnings to include the income in Subpart F income for the 2017 tax year. As the CBT treats Subpart F income as a dividend excludable from corporate income, any related expenses must also be included. The new legislation deems the expenses to be 5% of the dividend, effectively excluding 95% of dividends.
Interest Expense Limitation: The new legislation completely decouples the CBT from the federal interest expense limitations. The federal limitation still applies to shareholders of S corporations, as well as other non-corporate taxpayers.
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