The U.S. Department of the Treasury announced welcome news for Connecticut small businesses this week, blessing a workaround to limitations on the deduction of state and local taxes implemented as a result of federal tax reform. 

Although most individuals and businesses benefited from the 2017 federal changes, those in high tax states like Connecticut were impacted by a $10,000 cap on federal deductions for state and local taxes. 

Connecticut lawmakers, like some of their counterparts in other states, looked for a workaround for these limits. The General Assembly ultimately created two measures, which were found in Public Act 18-49. 

The first was aimed at tax relief for individuals related to their property tax.

Under the proposal, municipalities could allow taxpayers to make voluntary payments to approved charitable organizations, or "community supporting organizations," in lieu of paying local property taxes, in exchange for a corresponding tax credit.

Those payments could then be deducted from federal income taxes as charitable contributions, which were not capped. The Internal Revenue Service quickly adopted rules that invalidated this workaround. 

Pass-Through Entity Tax

The legislature's second relief measure was the creation of a new tax paid at the business entity level

The pass-through entity tax mitigates the loss of SALT deductions for small businesses that pay their taxes through the personal income tax—partnerships, S corporations, and LLCs treated as partnerships.

Many feared the IRS would also adopt rules nullifying the pass-through entity tax workaround.

Like business taxes paid by non-pass-through entities, PET is paid at the business level rather than the personal level and, as a result, is fully deductible from federal income taxes as a business expense.

That state tax is then offset by a personal income tax credit that effectively negates the impact of the federal cap on deductions.

Since enactment in Connecticut, many feared the IRS would also adopt rules nullifying the pass-through entity tax workaround.

Regulations

This week's Treasury announcement puts those fears to bed.

In fact, the agencies noted that state and local taxes imposed at the entity level on pass-through entities are permitted as a deduction and this "is consistent with the longstanding position" of Treasury and the Internal Revenue Service.

State and local taxes imposed at the entity level on pass-through entities are permitted as a deduction.

Treasury and the IRS plan to issue regulations clarifying that businesses organized as partnerships or S corporations that pay an entity-level state tax can deduct the taxes.

Those taxes would not be subject to the SALT deduction cap on the returns of partners and shareholders in the businesses.

Connecticut Concerns

While this announcement is welcome news, Connecticut small businesses owners will not benefit as much as those in other states.

Only one year after passing the pass-through entity tax workaround to benefit business owners, lawmakers reduced the tax credit by six percentage points—approximately $53 million—and used it to help balance the state budget.

It is time for the state legislature to reverse course on the pass-through entity tax credit reduction. 

This was little more than a money grab from the state’s smallest employers. 

With so many businesses shut down for the better part of 2020, it is time for the legislature to reverse course on the pass-through entity tax credit reduction.