Incentives Watch: Connecticut's New Pass-Through SALT Cap Workaround

 Internal Revenue Service Building

The state, local, and property tax deduction cap introduced by the 2017 federal tax act (Pub. L. No. 115-97) has mobilized high-tax states into action. Predicting an outflow of wealthy residents, New York had their fears realized when AllianceBernstein announced they would be moving from Manhattan to Nashville. More departures were announced when I Squared Capital’s founders relocated to Florida which has no personal income tax and lower property taxes (the weather may have played a role as well). Although states have yet to attain control over the weather, policies implemented by a neighboring high-tax state, Connecticut, are aimed to stem the bleeding. Connecticut’s new pass-through entity level tax is just the latest broadside in the national competition to attract and retain the country’s wealth and power. 

Legislation signed on May 31, 2018, S.B. 11, lays out an entity tax increase and corresponding individual income tax credit regime. Private partnerships (certain exclusions apply for publicly traded partnerships), limited liability companies, and S-corporations are now subject to an entity level tax of 6.99 percent on I.R.C. § 702 income, with certain Connecticut adjustments. Connecticut then offers a corresponding income tax credit for members, partners, and shareholders of the pass-through entity equal to the amount of the owner’s pro-rata share of the entity level tax. Connecticut also added provisions concerning nonresidents who file a combined return, refundability of the credit for individuals, and a carry-forward period for owner-companies. The bill makes several other tax changes as well, covered by previous blog posts by Michel Daze and Lindsay Trasko

The legislation shifts the tax burden of pass-through entity owners to generate larger federal tax deductions. State individual income tax and property tax deductions are now limited to $10,000 per year, meaning that high-income individuals in high-tax states now pay more to live in the state. The new regime translates a limited state income tax payment into a fully deductible business expense, maintaining Connecticut resident’s overall tax burden. Connecticut fears a mass migration of wealth to lower-tax states, and the regime offers a carrot to high-income individuals and businesses that choose to stay. 

In the quest for an acceptable workaround, Connecticut has blazed its own path. The Internal Revenue Service’s critiques of high tax states’ plans clouds the future of state, local, and property tax workarounds. The IRS has yet to release specific guidance, but recently affirmed that “federal law controls the proper characterization of payments for federal income tax purposes.” With the mid-point of 2018 having come and gone, tax practitioners may not need to wait long before workarounds are dealt with, for better or for worse. 

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: How should the IRS react to state attempts to work around the SALT cap deduction limit? 

For more information on the impact of Pub. L. No. 115-97, examine Bloomberg Tax’s Tax Reform Roadmap, showing detailed comparisons between pre-reform law and impending changes, with pertinent cites attached. 

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