Taxing Partners, Skirting Deduction Cap Evolves in Connecticut

Daily Tax Report: State provides authoritative coverage of state and local tax developments across the 50 U.S. states and the District of Columbia, tracking legislative and regulatory updates,...

By Che Odom

Business interests are embracing a bill awaiting Connecticut Gov. Dannel Malloy’s (D) signature that would alter the taxation of partnerships and certain limited liability companies.

The legislation also would help owners of those businesses get around a new limit on the federal deduction for taxes paid to state and local governments.

Supporters of the bill hope to get other states to follow suit.

“This is a long-term project, but we believe that once a handful of states adopt this relief, other states will follow suit,” Brian Reardon, founder of Reardon Consulting LLC and president of the S Corporation Association, told Bloomberg Tax. “It really does make a state more attractive to employers, and at no expense to the state. It’s a freebie.”

Partnerships, S corporations, limited liability companies, and certain trusts aren’t subject to federal income tax. The tax obligation passes through to the individual partners or owners behind the business.

Some states apply an income tax to the entity. Under the sweeping 2017 federal tax act ( Pub. L. No. 115-97), such entities can fully deduct the cost of state and local income taxes as a business expense. However, owners would only be able to deduct up to $10,000 on their individual tax returns for taxes paid to state and local governments.

‘Virtuous Circle’

The bill on Malloy’s desk ( S.B.11) and proposals being developed in a handful of other states attempt to mitigate the increased tax burden. The Connecticut bill would tax the net income of the pass-through business and provide an equal, offsetting individual income tax credit for the entity’s members or owners.

“The bottom line is we maintain the benefit that they tried to take away, and no one ends up paying more taxes,” Kevin Sullivan, outgoing commissioner of Connecticut’s Department of Revenue Services, told Bloomberg Tax. “It just passes through different hands to get there.”

Sullivan, who retired as commissioner May 10, said he was confident that the measure will pass Internal Revenue Service scrutiny.

The bill creates what Sullivan calls a “virtuous circle,” because even though the taxes on the entity will “inevitably reduce the distribution” of income to the individual owners, Connecticut would be able to “grant a credit exactly equal to that fiscal impact,” he said.

The S Corporation Association, which advocates on behalf of companies with that business organization, is working with businesses in New York, California, Michigan, and Wisconsin to push for Connecticut-type legislation in those states, while still pushing for a change at the federal level.

Nonresident Taxpayers

One challenge facing the bill’s approach is that states must comply with constitutional strictures that prevent them from favoring resident over nonresident taxpayers.

In the case of the Connecticut bill, “Connecticut needs to be sure to afford the credit to nonresidents as well as residents,” Shirley Sicilian, national director of State and Local Tax Controversy in KPMG LLP’s Washington National Tax office, told Bloomberg Tax.

“It’s true that this approach isn’t going to eliminate the partner-level tax that a nonresident may then owe in his or her home state, if that home state doesn’t have a similar entity-level tax and credit,” she added. “But that problem, as important as it is, probably isn’t a constitutional one.”

Apportioning Income

The approach, while generally supported by certain business groups and tax practitioners, may face some challenges.

“This approach assumes that any income earned from multistate activities is effectively apportioned the same whether it is taxed at the entity level or taxed at the individual level,” Helen Hecht, general counsel to the Multistate Tax Commission, told Bloomberg Tax.

A state may only tax income that can be attributed to earnings derived within the state, which requires jurisdictions to develop formulas for divvying up multistate income.

“When that’s done, the apportionment information, like the income-related information, can flow through and be reported by the individual partners,” Hecht said. “So that is, at least, theoretically simple.”

Determining Residency

Except it isn’t simple when partnerships are involved—many of which are owned by other partnerships, which in turn may be owned by partnerships. Most states address this by treating some forms of partnership income as sourced entirely to the individual owner’s state of residency, and typically includes passive investments.

“For the treatment to be the same when the income is taxed at the entity level, the entity would have to apportion not based on some type of factors, but based on the partners residency,” Hecht said.

Many partnerships won’t know the residency of all their direct and indirect partners. “For example, large publicly traded partnerships or partnerships that engage in multitier investment activities will not always know who the indirect partners are, let alone their residency status,” Hecht said. “So that may limit the usefulness of this approach.”

To contact the reporter on this story: Che Odom in Washington at codom@bloombergtax.com

To contact the editor responsible for this story: Ryan C. Tuck at rtuck@bloombergtax.com

Copyright © 2018 Tax Management Inc. All Rights Reserved.

Request Daily Tax Report: State