By Nicholas J. Bertha JD
Director of Wealth and Trust Planning
As most now know, last year’s tax reform act (the American Tax Cuts and Jobs Act, or ATCJA) put a $10,000 ceiling on the ability to deduct state and local taxes (e.g. income and real property tax) on one’s Federal income tax return. In high-tax states, and Connecticut is certainly one of those, this amounts to a meaningful increase in Federal income tax. A few of these high-tax states have attempted to counter this with workarounds at the state level, with varying degrees of creativity, practicality and likelihood of success. For example, Connecticut, New York and others have attempted to allow payments of real estate tax to qualify as charitable contributions (which remain fully deductible). The IRS, of course, was not amused and soon proposed regulations disallowing it.
Connecticut is back for more, and with impressive creativity.
To make sense of it we need to first take a step back. Many high earners source their income via “pass-through” entities, like LLCs and LPs. Think hedge funds, private equity firms and professional practices.
Connecticut did not formerly have a state-level tax on pass-through entities. Instead, 100% of pass-through income flowed through to the owner and was taxed by CT at the individual level. Post-ATCJA, the full impact of the $10,000 cap hits these taxpayers.
To help relieve the pain (and, presumably, the pressure it would put on Connecticut to reduce state tax burdens), the state came up with a workaround for people who derive their income from pass-throughs: shift a portion of the tax burden from personal income (where it is subject to the deductibility cap) to the “pass-through” entity that is the source of that income, thereby reducing taxable personal income and, by extension, the pain of the lost deduction.
Here’s how it works. The state will impose a new 6.99% income tax on the taxable income of pass-through entities, which are not affected by the $10,000 deductibility cap. In so doing, they are deliberately reducing the owner’s net taxable personal income from the pass-through, which in turn reduces the amount by which that owner’s state tax will exceed the $10,000 cap. This is, of course, because the lower the taxable income, the lower the amount of state income tax that is generated.
Nice, right? But at this point you may be thinking, OK but the owner is still out the income that was taxed away at the entity level. Yes, but to make up for it, the new law provides a tax credit equaling most of the income lost due to the entity tax.
Let’s walk through an example: Ms. Smith, is the manager of a Greenwich-based hedge fund. Her business is structured as an LLC and her share of net income from it is $1 million. Without this change in state law, that $1 million would have flowed through to both her Federal and Connecticut tax return. On the Connecticut return that would have generated $69,900 of state income tax, which would have been deductible on her Federal 1040, but only up to the new $10,000 SALT limitation. With the change, the state will impose a $69,900 tax on the LLC at the entity level, with the result that the net income flowing through to Smith from the LLC will be $930,100 as opposed to the $1,000,000. Then, it will reimburse her for most of the $69,900 of income that she did not receive from the LLC because of the entity level tax, by giving her a credit against her CT income tax bill. At the same time, the amount of taxable income she will report on her federal return is now $69,900 lower than it would have been.....exactly the amount by which it would have been reduced had she paid the tax at the state level on the full $1mm and been able to deduct the entire amount of that tax paid. Presto! Chango!
Now, we’re not all owners of pass-through entities, but you have to give the Nutmeg State some credit. Let’s encourage even more creativity!
Nicholas J. Bertha JD
Director of Wealth and Trust Planning