May 17, 2018 Connecticut lawmakers pass "An Act Concerning Connecticut's Response To Federal Tax Reform" On May 9, 2018, the Connecticut General Assembly passed SB 11, "An Act Concerning Connecticut's Response To Federal Tax Reform" (the Bill). Once enacted, the Bill will make the following changes to Connecticut's tax laws: — Impose a new 6.99% income tax on most pass-through entities (PTEs) and provide a credit to offset the tax at the personal or corporate income tax level — Allow municipalities to provide a property tax credit to eligible taxpayers who make voluntary payments to municipally-approved "community supporting organizations" — Require individuals, for personal income tax purposes, to apportion the federal deduction for bonus depreciation over four tax years — Require individuals and corporations, for personal income and corporation business tax (CBT) purposes respectively, to apportion the federal asset expensing deduction over five years — Specify that, for purposes of calculating the dividends received deduction under the CBT, expenses related to dividends equal 5% of all dividends received by a company during an income year (in essence, CBT taxpayers can only deduct 95% of the dividends received from 100% owned subsidiaries) — Decouple from the new federal business expense interest limitation in Internal Revenue Code (IRC) Section 163(j) The Bill also contains changes to the Connecticut estate tax, requires the economic and community development commissioner to study opportunity zones, and authorizes the Connecticut Green Bank to secure obligations under a lease-purchase agreement (not discussed in this Tax Alert.) The Bill is expected to be signed by Governor Malloy. As noted, the Bill would implement a legislative approach as a 'workaround' to the cap on itemizing individuals' state and local tax (SALT) deduction in the recently enacted federal Tax Cuts and Jobs Act (TCJA) (P.L. 115-97). For tax years beginning on or after January 1, 2018, the TCJA imposes an annual $10,000 limitation on the SALT deduction an individual may claim. However, the TCJA retained the ability of all taxpayers to deduct taxes imposed on businesses, including PTEs. The Bill attempts to circumvent the SALT deduction limitation imposed on individuals by the TCJA by imposing a new entity-level tax on PTEs which, the proponents hope, would flow through to individual owners and remain deductible for US federal income tax purposes. The Bill further provides that PTE owners could claim a credit against their income tax liabilities for their share of the PTE tax paid by the PTE. Entity-level tax on PTEs (Effective TY2018) Imposition The Bill would impose a new entity-level tax on PTEs, including S corporations, partnerships, and LLCs treated as partnerships for federal income tax purposes, at a rate of 6.99%. Publicly traded partnerships would not be subject to the tax if they agreed to file an annual return reporting certain information on each unit holder whose Connecticut-source income exceeds $500. In tiered partnerships, if the member of the PTE were another PTE (the upper-tier entity), the lower-tier entity would have to subtract the upper-tier entity's distributive share of income or add the upper-tier entity's distributive share of loss, as applicable, when calculating its taxable income. Tax base The new PTE tax would be calculated based on either the entity's taxable income, as determined for federal income tax purposes, that is derived from Connecticut sources (Connecticut-source income), or, at the election of the PTE, based on an alternative tax base. The Connecticut-source income base is the sum of the items computed in IRC Section 702(a), to the extent derived from Connecticut sources, and as increased or decreased by any modification described in Section 12-701 of the Connecticut General Statutes. The alternative tax base election appears to allow a PTE to pay tax based only on income associated with nonresident individuals and a portion of residents' individual income that is not taxed elsewhere. This methodology purportedly would eliminate from PTE taxation any income associated with corporate or tax-exempt entities. The alternative tax base is defined as the sum of a PTE's "modified Connecticut-source income" plus its "resident portion of unsourced income." A PTE's "modified Connecticut-source income" equals its Connecticut-source income multiplied by a percentage equal to the sum of ownership interests in the entity held by members that are: (1) subject to personal income tax, or (2) PTEs subject to the entity tax, to the extent the PTEs are owned by individuals subject to the income tax. A PTE's "resident portion of unsourced income" is calculated by multiplying "unsourced income" by a percentage equal to the sum of the ownership interest in the PTE that belongs to Connecticut residents. "Unsourced income" equals: (1) the PTE's net income for federal income tax purposes, plus or minus state modifications; minus (2) the PTE's Connecticut-sourced income (without any adjustments for tiered entities); minus (3) the PTE's net federal income that is derived from or connected to sources in another state with jurisdiction to tax the PTE, plus or minus state modifications. Offsetting credits The new PTE tax would be offset by a Connecticut income tax credit distributed to PTE partners, owners and shareholders (collectively, PTE owners). The credit equals the PTE owner's distributive share of the PTE tax paid by the PTE multiplied by 93.01%. The Bill would also authorize a personal income tax credit for members of the PTE that have paid taxes to other states, or the District of Columbia, that are substantially similar to the PTE tax. For Connecticut personal income tax purposes, this would be a refundable tax credit. For corporate PTE owners, any amount of credit exceeding the corporation's Connecticut corporate tax liability would be carried forward to future tax years. Combined filings The Bill would allow PTEs to file a combined return with one or more commonly-owned PTEs that are also subject to the PTE tax. For purposes of the PTE tax, the term "commonly-owned" means that more than 80% of the voting control of a PTE is directly or indirectly owned, as determined under federal tax law, by a common owner(s). PTEs that choose to file on a combined basis would have to notify the Commissioner in writing and provide a written consent of the other PTEs to file on a combined basis, by the PTE's due date or extended due date for filing the PTE tax return. Estimated payments Connecticut income taxpayers must make estimated payments. Under the Bill, the PTE quarterly estimated payments would generally equal 25% of the "required annual payment" and would be due on the 15th day of the tax year's fourth, sixth, and ninth month, and on the 15th day of the first month of the next tax year. The Bill would also authorize PTEs to make payments based on the "annualized income installment" calculation method. Presumably, because PTE members receive offsetting credits for the PTE tax paid on their behalf, such members would no longer be required to make quarterly payments on the income they receive from the PTE. Nonresidents Nonresident individuals would not be required to file a Connecticut personal income tax return if their only income for the tax year derives from PTEs that are paying the PTE tax. Connecticut's existing mandatory composite income tax return regime would be repealed. Affected PTEs would need to report the pro-rated share of the PTE tax paid on behalf of each of their shareholders, partners or members. Presumably, the intent is for PTE owners to have evidence of tax paid to Connecticut in order to claim any other state tax credit (OSTC) in their home state for their distributive share of the entity tax. The applicability of the OSTC to this new entity tax for nonresident PTE partners, however, will depend on the application of the various tax laws of the 40+ state jurisdictions that impose a personal income tax.1 Municipal charitable deduction/ property tax credit (Effective TY2018) Effective July 1, 2018, Connecticut municipalities would be allowed to provide for a residential property tax credit not to exceed the amount of voluntary cash donations made by the owner of a residential property located in the municipality to a "community supporting organization" during the preceding tax year. The provision is intended to give municipalities revenues towards community services while at the same time theoretically allowing individuals to claim a federal SALT deduction in the form of a charitable contribution. Under the Bill, a "community supporting organization" means an organization that is: (A) exempt from taxation under IRC Section 501(c)(3), and (B) organized solely to support municipal expenditures for public programs and services, including public education. A "municipality" means "any town, city or borough, consolidated town and city, or consolidated town and borough." The tax credit authorized by a municipality may not exceed the lesser of either: (1) the amount of property tax owed, or (2) 85% of the taxpayer's donations. To claim the property tax credit, a taxpayer would have to submit an application to the tax collector in the municipality in which the property is located, between January 1 and April 1 of the fiscal year preceding the fiscal year for which the taxpayer will claim the credit. The application would have to evidence the amount of the taxpayer's donations. The taxpayer would also have to submit an affidavit affirming that the donations were made in cash and were voluntary, unrestricted, and irrevocable. Further, a taxpayer would not be allowed to use the donations to claim a tax credit for more than one assessment year. Bonus depreciation and 100% expensing of business investments (Effective TY2017 & TY2018) The Bill would specifically decouple Connecticut income tax law from the bonus depreciation provisions of IRC Section 168(k) enacted under the TCJA. Applicable for tax years beginning on or after January 1, 2017 and to property placed in service after September 27, 2017, any additional depreciation under IRC Section 168(k), to the extent deductible in determined federal adjusted gross income (AGI), would be disallowed for individuals receiving income from PTEs. Individuals could, however, take the depreciation added back in computing Connecticut AGI as a 25% subtraction on their personal income tax return over the four succeeding tax years. Existing law disallows the federal bonus depreciation deduction for corporate business tax purposes. In addition, the Bill would require individuals and corporations to apportion the federal deduction for the cost of qualifying IRC Section 179 property over five years. For tax years beginning on and after January 1, 2018, individuals and corporations would have to add back 80% of the federal deduction in the first year. Taxpayers could then deduct 25% of the disallowed deduction in each of the four succeeding tax years. Expense addback to the Connecticut dividend received deduction (Effective TY2017) Applicable to tax years beginning on or after January 1, 2017, the Bill would also modify Conn. Stat. Section 12-217(a)(2), which relates to dividend deductions for corporate tax purposes. Specifically, the provision disallowing a deduction for expenses related to allowable dividends under the IRC would be amended to include a new provision specifying that expenses related to disallowed dividends equal 5% of all dividends received by a company during an income year. Notably, and unlike the other proposals in the Bill, this legislative change would apply retroactively to tax year 2017. Presumably, this effective date is intended to capture revenue from the one-time repatriation transition tax (RTT) deemed dividend under amended IRC Section 965. The net income associated with the disallowance of expenses related to dividends would be apportioned in accordance with existing apportionment rules. The initial bill provided for a 10% addback, but was amended to adjust the deemed expense amount to 5%, now in line with Massachusetts' 95% dividend received deduction. Recent DRS guidance had specified that the DRS would accept a 10% expense addback as the appropriate expense addback amount upon audit.2 This guidance was updated on May 11, 2018, to be consistent with the final version of the Bill containing the 5% addback. Further, the updated bill does not contain the provision of the initial bill that would have allowed a taxpayer to petition the Commissioner to use actual expenses. Decoupling from IRC Section 163(j) (Effective TY2018) Effective for income years beginning on or after January 1, 2018, the Bill includes a provision that decouples from IRC Section 163(j) in calculating Connecticut income. Accordingly, Connecticut would not adopt the provisions of either "new" IRC Section 163(j), nor the version of IRC Section 163(j) that existed before the TCJA was enacted. Implications The two SALT deduction workarounds in the Bill (i.e., the PTE tax and associated Connecticut personal income tax credit and the "charitable" deductions with the offsetting Connecticut personal income tax credit) depend in part on the IRS's application of these state law provisions under the federal income tax law. Variations of the charitable deduction workaround have been proposed or enacted in a number of other jurisdictions including California, Illinois and New York. Treasury Secretary Mnuchin and Acting Commissioner Kautter both have expressed skepticism that any of these state proposals work and have suggested that the IRS may challenge taxpayers claiming the deductions. The PTE tax is a novel state legislative workaround to the federal cap on the SALT tax deduction for PTE owners. Though other states impose entity-level taxes on PTEs, the viability of a PTE tax with the intent of preserving a federal tax deduction is still untested. However, many complications remain, including the credibility of the tax on nonresident PTE owners on their own resident state income tax returns. Also notable from a tax policy perspective, under the TCJA, the 100% expensing bonus depreciation provision (government revenue decrease) was intended to be complimentary to the limitation on net interest expense (government revenue increase). The originally introduced version of Connecticut's Bill only decoupled from the revenue decreasing expensing provision while maintaining conformity to the revenue increasing net interest expense limitation. The final version decoupled from IRC Section 163(j) in whole. Finally, the new 5% DRD expense disallowance relating to the Connecticut DRD is likely to result in a significant expansion of the Connecticut tax base for Connecticut taxpayers, especially for tax year 2017 with regard to the RTT deemed dividend under the TCJA. The Bill, as originally introduced was even more stringent and would have required a 10% expense dividend disallowance (in effect, allowing only a 90% DRD) but was subsequently amended to reduce the dividend expense disallowance to 5% of the dividend. ———————————————
——————————————— 1 See e.g., Cal. FTB Legal Ruling 2017-1 (Feb. 22, 2017). 2 Connecticut Department of Revenue Services, Office of the Commissioner Guidance, OCG-4, April 6, 2018, Rev. May 11, 2018. | |||||||||||||||||
| |||||||||||||||||
