Understanding the State’s Pass-Through Entity Tax

Small Business

It’s rare that a tax on business is a benefit to those it targets, but that’s exactly the purpose of Connecticut’s new 6.99% pass-through entity tax, or PET.   
That was one of the main messages at CBIA’s July 24 Navigating the New Pass-Through Entity Tax workshop in Hartford.
The timely event brought together four Connecticut tax experts: Shipman & Goodwin associate David Bigger; Connecticut Department of Revenue Services counsel Matt Dayton; Shipman & Goodwin partner Alan Lieberman; and BlumShapiro partner Tony Switajewski.
While federal tax reform benefited many businesses and individuals in the state, the loss of some state and local tax deductions has the potential to negatively impact certain businesses.

Connecticut’s Pass-Through Entity Tax

Lawmakers approved Connecticut’s PET at the end of the 2018 General Assembly session in an attempt to mitigate the loss of these state and local tax deductions for small businesses.
The new tax is designed specifically to ease the burden on owners and partners of pass-through entity businesses—partnerships, S corporations, and LLCs treated as partnerships—by enabling them to circumvent the new $10,000 annual cap on state and local tax deductions.
(The PET is not applicable to sole proprietorships, SMLLCs, publicly traded partnerships, or C corporations.)
Like the business taxes paid by non-pass-through entities, the 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.

PET allows owners and partners of pass-through entities to circumvent the new $10,000 federal cap on state and local tax deductions.

That tax is then offset by a new personal income tax credit that effectively negates the impact of the federal tax changes. 
"In the past nine months, we've seen some of the most significant reforms to the federal tax code in years,” CBIA vice president for government affairs Eric Gjede told workshop attendees.
"While many of these federal reforms were beneficial, the loss of certain state and local tax deductions would have a significant financial impact on many of Connecticut's small and midsize businesses.
“Thankfully, a handful of lawmakers, the state Department of Revenue Services, and representatives from CBIA member companies were able to work together on a new tax arrangement that would help minimize the impact of the loss of these deductions for most businesses."

Compliance Confusion

The whole point of the PET tax is to provide a benefit to business owners, so they can get the full state and local tax deduction, said Switajewski, adding that the intent is to put pass-through entity owners in the same place they were in before the federal tax law passed.
"The intent of the tax is that it will be neutral for Connecticut state tax purpose," said Bigger.
"Connecticut will not be out any money, and the taxpayer will not have to pay more taxes," although, he added, the PET may be unfavorable to out-of-state residents, depending on how their states are addressing federal tax reforms.
Despite the benefits of the new PET for businesses, guidelines issued by DRS left many in the business community confused about exactly how the tax applies to them and how to comply.
Recognizing that the early information provided by the state led to confusion, Dayton assured attendees DRS will continue issuing guidance, which will be posted at the agency's website, and said, "nothing is set in stone until that guidance appears."
"We don't have all the answers," Lieberman added. "The legislation was passed on the last day of session, and the DRS is still in the process of creating guidance and soliciting the tax community's input."

States Sue Federal Government

Switajewski pointed out the $10,000 cap on state and local tax deductions is temporary, (scheduled to sunset after Dec. 31, 2025), but that Congress could decide to extend it.
In response to the new limit on state and local tax deductions, Connecticut recently joined three other states—New York, New Jersey, and Maryland—in suing the federal government.
The suit, filed July 17 in Federal District Court in Manhattan, seeks an injunction against enforcement of the cap and calls the tax changes an "unconstitutional assault" on states' rights.

Shipman & Goodwin's Alan Lieberman

We strongly advise you not to wait until the lawsuit is resolved to comply with the new PET law.

"States have sued the federal government, saying the states have relied for 150 years on people being able to deduct SALT; you can't now take this away from us," Bigger said.
"I'm not convinced the suit will work, but I've been surprised in the past. We'll see how the courts will respond."
Lieberman sounded a note of caution for attendees: "We strongly advise you not to wait until the suit is resolved to comply with the new PET law."

IRS Pushes Back

This past May, the IRS announced it will issue proposed regulations addressing the deductibility of state and local tax payments for federal income tax purposes.
The notice explicitly targeted efforts by various states, including Connecticut, to skirt the new cap on state and local tax deductions.
The notice focused primarily on a strategy—represented in Connecticut's Public Act 18-49—designed to enable municipalities to allow eligible taxpayers to make voluntary payments to approved charitable "community supporting organizations" in exchange for a tax credit against their state and local taxes.
Those payments could then be deducted as charitable deductions, which are not capped, from federal income taxes.   
However, the IRS also said that it intends to look at state legislative proposals beyond those involving charitable deductions, which means that Connecticut's PET could also be in jeopardy.
Switajewski, however, doesn't think that's likely.

Will Tax Survive Federal Scrutiny?

"The whole point of the PET is to get [businesses] back to where they would have been before the cap," he said.
"The question is whether the IRS will allow the deduction at the entity level.
"There's been a lot of talk about ways to get around the cap, so the question is whether it will pass muster. It seems like Congress and the IRS will allow it."
Bigger made it clear, however, that whether the IRS allows eligible businesses to take the SALT deduction at the entity level or not, the new tax is now state law.

BlumShapiro's Tony Switajewski

There's been a lot of talk about ways to get around the cap, so the question is whether it will pass muster.

"As it stands, Connecticut law says this tax is required," he said.
"So, the IRS may say you can't take the deduction, but that's separate from the new law saying you have to pay the PET."
He noted, however, that should the IRS take adverse action, the PET would no longer serve the state's purpose of giving relief to certain businesses and, therefore, would be rescinded.

For more information, contact CBIA's Eric Gjede (860.480.1784) | @egjede


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