Connecticut Wants Small Business Owners to Get Their SALT Deduction, Just Not as Much as They Used To

In 2018, Connecticut implemented a Pass-Through Entity Tax (“PE tax”) that imposes a tax on partnerships (including multi-member LLCs) and S-Corporations doing business in Connecticut. The tax, generally equal to 6.99% of Connecticut-source taxable income, replaces the state’s composite income tax and was designed, in part, to help small business owners circumvent the newly imposed limitations on individual taxpayers deducting state and local taxes (“SALT”). Now, only one year later, Connecticut is scaling back the benefit provided to taxpayers.

How was a new tax intended to help taxpayers?

Thanks to the Tax Cuts and Jobs Act (“TCJA”), individual taxpayers are limited to a $10,000 SALT deduction on their personal income tax return. Businesses, however, are not subject to the same limitation. By imposing this PE tax on businesses (which are able to fully deduct the cost of the tax) and providing a tax credit to the business’s owners, the state effectively turned an individual (and potentially non-deductible) individual tax into a fully deductible business tax.

How does this new tax work?

The new tax is imposed on businesses; however, the business’s owners were to receive a tax credit against their individual Connecticut income tax equal to 93.01% of the PE tax. Let’s look at an example:

  • Alex is a single taxpayer living in Connecticut
  • Alex owns ABC Co, a business that had $500,000 of Connecticut-source taxable income in 2018

Under the Old CT Tax Rules

  • Alex would have paid individual Connecticut income tax of ~$35,000 (an effective tax rate of 7%)
  • Thanks to the TCJA’s limitation, Alex would only have been able to deduct $10,000 of this tax on her federal income tax return. At a federal tax rate of ~35%, this deduction would save Alex $3,500 in federal tax
  • The net tax effect is:
  • CT individual income tax: $35,000
  • Federal tax savings: $3,500
  • Net tax effect: $31,500

Under the Original PE Tax Rules

  • ABC Co would pay ~$35,000 of PE tax ($500,000 x 6.99%)
  • Alex would still incur a Connecticut tax liability of $35,000, however, it would be offset by a tax credit equal to 93.01% of the PE tax ($35,000 x 93.01% = ~$32,500)
    • Individual CT tax: $35,000
    • PE tax credit: ($32,500)
    • Individual CT tax after credit: $2,500
  • The $35,000 PE tax paid is fully deductible by ABC Co, decreasing Alex’s taxable income when calculating her federal income tax. At a federal tax rate of ~35%, the savings from ABC Co deducting the PE tax is ~$12,250
  • The net tax effect is:
    • PE tax: $35,000
    • CT individual income tax: $2,500
    • Federal tax savings: ($12,500)
    • Net tax effect: $25,000
  • By implementing the PE tax, Connecticut both increased the amount of tax revenue to the stage (from $35,000 to $37,500) and decreased Alex’s overall tax burden by $6,500

What changed that is making it less beneficial to taxpayers?

Connecticut decided to decrease the credit that taxpayers can use to offset their individual income tax from 93.01% of the PE tax to 87.5% of the PE tax. How will this affect Alex?

Under the New PE Tax Rules

  • Everything is the same as the original rules except that the PE tax credit is decreased from 93.01% to 87.5%
  • Alex’s Connecticut tax liability would be:
    • Individual CT tax: $35,000
    • PE tax credit: $30,625
    • Individual CT tax after credit: $4,375
  • The next tax effect is:
    • PE tax: $35,000
    • CT individual income tax: $4,375
    • Federal tax savings: ($12,500)
    • Net tax effect: $26,875
  • The decreased credit cost Alex $1,875 in additional tax

In conclusion…

It’s important to be aware of the implications of changes to the tax law, both on the federal and on the state and local levels. This is an evolving topic, and we’re still waiting to see if the IRS will challenge the ability for businesses to deduct this tax, so check back to see if any new developments have come up. If you’re not sure how this change affects you, give us a call, we can help you make sense of it!

This change to the CT tax code only touches on one area of a topic that is too big to cover in this article. You should always consult your tax advisor to review your specific situation before making any planning decisions.