Yeah. They actually called the new law “An Act Concerning Connecticut’s Response To Federal Tax Reform.” Gee – I wonder what this law is about?

 

Well, the text of the Bill is 43 pages long. So I doubt all of it is just a response to Federal Tax Reform.

 

But there are two important sections of the Act that I want to share with you now. We’ll get to the rest when we get to it.

 

As with any tax law written by the CT legislature, the bill starts off with a definitions section.

But then there is this (The Entity-level tax section):

 

(1)(b)Each affected business entity that is required to file a return under the provisions of section 12-726 of the general statutes, as amended by this act, shall, on or before the fifteenth day of the third month following the close of each taxable year, pay to the commissioner a tax in an amount equal to (1) (A) the separately and nonseparately computed items, as described in Section 702(a) of the Internal Revenue Code, of the affected business entity, to the extent derived from or connected with sources within this state, as determined under the provisions of chapter 229 of the general statutes, (B) as increased or decreased by any modification described in section 12-701 of the general statutes, as amended by this act, that relates to an item of the affected business entity’s income, gain, loss or deduction, to the extent derived from or connected with sources within this state, as determined under the provisions of chapter 229 of the general statutes, (2) multiplied by six and ninety-nine-hundredths per cent. If the amount calculated under subdivision (1) of this subsection results in a net loss, such net loss may be carried forward to succeeding taxable years until fully used. Payment shall be made with the return that is required to be filed under section 12-726 of the general statutes, as amended by this act.

What we have here is an entity level tax imposed on pass-through entities in the amount of 6.99%.

And then there is this:

(f) (1) (A) Each person that is subject to the tax under chapter 229 of the general statutes [income tax] and is a member shall be entitled to a credit against the tax imposed under said chapter, other than the tax imposed under section 12-707 of the general statutes. Such credit shall be in an amount equal to such person’s direct and indirect pro rata share of the tax paid under this section by any affected business entity of which such person is a member multiplied by ninety-three and one-hundredths per cent. If the amount of the credit allowed pursuant to this subdivision exceeds such person’s tax liability for the tax imposed under said chapter, the commissioner shall treat such excess as an overpayment and, except as provided under section 12-739 or 12-742 of the general statutes, shall refund the amount of such excess, without interest, to such person.

So what we have here is a 93.01% credit for each taxpayer’s share of the taxes paid on his/her behalf by his/her business.

Whyyyyyy?

At some point, if I get around to it, I might write an opinion piece of what the CT government has to gain from these (and other) changes to the CT Tax regime. But the obvious purpose of the above provisions is to do exactly what the short title of the Bill says it is doing. It is a “Response” to “Federal Tax Reform.”

See, when Congress passed the Tax Cuts and Jobs Act (TCJA), it was a direct-hit at high-tax states like Connecticut. (Some might call the majority of these states “Blue states.” In my opinion though, most of these states are gray and gray and in-the-red all over.)

Congress Capped Itemized deductions for State and Local Taxes (SALT) at $10,000.

What that means is this: previously State income taxes were deductible on an individual Taxpayer’s Schedule A. But now, if your state and local taxes (Real Estate, Car taxes, Income taxes, etc) exceed $10,000 you are no longer going to get a deduction above the $10,000.

This new measure by Connecticut attempts to bring some of that deduction back for owners of pass-through entities in the form of an “Ordinary and Necessary Business expense.”

 

See, when a business needs to pay a tax in order to do business in a state, it is a deduction. It doesn’t go on the individual’s Schedule A, it goes on the entity’s return.

 

A quick ( and very simple) illustration to explain what I am talking about.( This is rough, and not intended to be 100% accurate, just easy to understand. For example, I am treating all of the K-1 as if it is taxable income below. Obviously it is not all taxable income. Consult a professional!)

 

Tony is a partner in a law firm. Tony gets a K-1 every year for 50% of the partnership’s income.

in 2018, the partnership generates $175,000 in taxable income attributable to Tony (without taking into account the new tax)

On that $175,000 – the business already paid an entity tax of 6.99%, or $12,232.50. That means that Tony’s K-1 is going to show $162,767.50 in income attributable to Tony from the business.

Tony’s Federal Income Tax return will report that $162,767.50 amount as income.

Tony’s CT tax on that income is roughly $8,816.05.

based on these simplified (and TOTALLY NOT ACTUALLY ACCURATE) numbers, Tony will get a tax credit equal to $12,232.50 x 93.01% on his Connecticut tax return, or $11377.45.

 

I hope that makes sense.

Of course… in this simplified example… Tony is probably going to get a refund of  $2,561.40 on his State tax return, which will be taxable on his 2019 Federal tax return.

 

What do you think? was this a good move by Connecticut? Will it stand up to scrutiny? Will the IRS issue regulations to blunt the impact?

Please tell me what I got wrong in the comments below and let me know what else you would like us to write about concerning this topic.