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Connecticut's PTET, one year in: the workaround the IRS has not touched

A 6.99% entity tax, a 93.01% member credit, and a Treasury that has said nothing about either

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 5 sections
  1. What the statute actually does
  2. What Treasury has said, and not said
  3. The second-order effects
  4. What remains unclear, and what to watch
  5. Sources

onnecticut's pass-through entity tax is a year into its first filing season, and the thing to notice is what has not happened. The Internal Revenue Service has issued no notice, no proposed regulation, no private letter ruling, and no informal comment disallowing the federal deduction that Connecticut's entity-level tax is designed to generate. Fifteen months after Governor Malloy signed the statute, Treasury's silence is itself the story.

The Connecticut PTET was the first of its kind, enacted as Public Act 18-49 on May 31, 2018, codified at Conn. Gen. Stat. §§ 12-699 through 12-699a. It taxes pass-through entities at 6.99% on Connecticut-source income and gives the members a refundable credit against their personal income tax equal to 93.01% of the entity-level tax paid on their behalf. Wisconsin followed in December 2018. Oklahoma and Louisiana enacted their versions in the spring of 2019. New Jersey has a bill in committee. At least a dozen other state revenue departments are watching to see whether the federal shoe drops.

What the statute actually does

The Connecticut mechanism is straightforward once you see it written out. An S corporation, a partnership, or an LLC treated as a partnership that does business in Connecticut or has income connected with Connecticut sources is an "affected business entity" under Conn. Gen. Stat. § 12-699(a)(1). That entity is subject, under § 12-699(c)(1), to a tax of 6.99% on its Connecticut-source income, calculated under the separately and nonseparately stated items of IRC § 702(a) for partnerships and IRC § 1366 for S corporations, with the state-level modifications in § 12-701.

The entity files Form CT-1065/CT-1120SI. It remits the tax. For calendar-year filers, estimated payments are due April 15, June 15, September 15, and January 15, matching the individual income-tax schedule. The entity deducts the tax on its federal return under IRC § 164, because a tax imposed on the entity is a business tax of the entity, not a state income tax of the owner. That is the entire point. The entity-level deduction is not capped at $10,000. It is not capped at anything. Connecticut wrote the tax specifically to sit outside the SALT cap at IRC § 164(b)(6).

The members then compute their Connecticut personal income tax as usual, and under Conn. Gen. Stat. § 12-704d take a refundable credit equal to 93.01% of the entity-level tax paid on their distributive share. The 93.01% is not arbitrary. It is the complement of the 6.99% entity rate applied against itself, and it is the number the drafters settled on to make the arithmetic as close to revenue-neutral for the state as possible while still generating a federal deduction the cap no longer allows.

The tax is mandatory. Connecticut did not give entities an election. Every partnership, every S corporation, every multi-member LLC with Connecticut-source income owes the 6.99%, full stop. That is the single structural choice that most distinguishes the Connecticut statute from everything that has come after it. Wisconsin's version, at Wis. Stat. § 71.21(6), is elective. Louisiana's version, under S.B. 223 signed June 2019, is elective. Oklahoma's Pass-Through Entity Tax Equity Act of 2019 at 68 O.S. § 2355.1P-1 et seq. is elective. Connecticut made a bet that mandatory was harder for Treasury to characterize as a taxpayer-initiated evasion, and fifteen months later that bet has not been called.

For more on how the $10,000 SALT cap at IRC § 164(b)(6) created the pressure the states are now responding to, see our November 2018 piece on the SALT cap and early workarounds. For how the PTET sits on top of the ordinary Connecticut LLC maintenance stack, see the December 2018 Connecticut formation guide.

What Treasury has said, and not said

Treasury's public position on the SALT workarounds is concentrated in two places, and neither of them is about PTETs.

The first is IRS Notice 2018-54, issued May 23, 2018, eight days before Governor Malloy signed PA 18-49. The notice was a shot across the bow at the New York, New Jersey, and Connecticut charitable-fund workarounds. Those schemes asked residents to "donate" to a state-controlled charity in exchange for a credit against state income tax, then to deduct the donation federally under IRC § 170 without the SALT cap. Notice 2018-54 announced that proposed regulations would treat those donations as quid pro quo payments, not charitable contributions, to the extent of the state credit received. The proposed regulations followed in August 2018. The final regulations, published in the Federal Register on June 13, 2019, adopted that position largely unchanged. Treas. Reg. § 1.170A-1(h)(3) now requires a charitable deduction to be reduced by the amount of any state or local tax credit received in return. The charitable workaround is dead, or nearly so.

The second is the substantive regulatory work on IRC § 164 itself. The proposed regulations at REG-112176-18 (August 2018) were aimed squarely at charitable credits. They did not address entity-level taxes. The final regulations under Treas. Reg. § 1.164-3, finalized June 2019, likewise confirm that state income taxes paid by an individual at the individual level are subject to the $10,000 cap, and do not address the question of a state income tax paid at the entity level by a partnership or S corporation.

That silence is the whole game. A tax imposed on a pass-through entity has been deductible by the entity under § 164 for as long as § 164 has existed. The deduction for state and local taxes paid by a trade or business was not written into IRC § 164(b)(6), and no final regulation has narrowed it. Until Treasury speaks, the Connecticut PTET generates a real federal deduction for the entity and reduces each member's federal taxable income accordingly.

Practitioners have been reading the tea leaves all year. In May 2019, senior IRS officials told the ABA Tax Section that Treasury was "studying" the PTET question but had no near-term plan to issue guidance. In July 2019, Acting Assistant Secretary David Kautter confirmed publicly that entity-level taxes were distinguishable from the charitable workarounds and that Treasury was not, for now, treating them the same. Nothing in either statement is a blessing. Both are the absence of a rebuke, which in tax is often enough to act on.

The second-order effects

An entity-level tax sounds mechanical. In operation it reshapes a surprising number of decisions.

It makes the choice of entity matter less at the federal margin. Before TCJA, a Connecticut dentist operating as a single-member PLLC and a Connecticut dentist operating as an S corporation had different payroll and self-employment-tax profiles but similar exposure to state income tax. After TCJA and before the PTET, the S corporation's shareholders got hit by the SALT cap at the individual level and the PLLC's sole member (a disregarded entity, so the owner was the taxpayer) got hit the same way. After the PTET, the S corporation pays 6.99% at the entity level and its owners get a federal deduction at the entity level. The disregarded single-member LLC does not, because a single- member LLC is not an "affected business entity" under § 12-699(a)(1); it has no partnership or S-corp return to file. The practical effect is that two-member-or-more formations and S-elections look better on the margin in Connecticut than single-member LLCs, purely because of who is allowed into the PTET. We have not yet seen an adviser's memo recommending a sham partner for federal tax purposes, but the incentive exists.

It changes the math on composite returns for nonresident members. Connecticut has offered composite filing for years. With the PTET, the entity-level tax effectively replaces the composite mechanism for many partnerships, and the credit at § 12-704d ensures that Connecticut residents are not double-taxed. Nonresident members of a Connecticut partnership whose home state also taxes the partnership's income get a trickier question: does their home state's resident credit for taxes paid to Connecticut apply to an entity-level tax? New York and Massachusetts have both clarified that it does, in bulletins issued this spring. Other states are silent. A Connecticut PTET paid by an entity with New Jersey resident partners is, for now, a credit those partners can claim against New Jersey income tax under N.J.S.A. § 54A:4-1, because the tax is "on income" and is "paid by" the partnership on their behalf. That interpretation could change. So could the availability of the federal deduction.

It also raises the question of what happens in a sale. A Connecticut S corporation that is sold in an asset sale will generate gain at the entity level, which will flow through to the shareholders. If the sale closes in 2020, the PTET will apply to that gain at 6.99%. The shareholders will get the 93.01% credit. The federal deduction will flow to the entity. The net state tax paid, in cash, is small. The federal benefit, for a high-income shareholder, can be six figures. That is a large enough swing that a Connecticut-source sale closing in December vs January of a given year is, all else equal, worth running the math on.

What remains unclear, and what to watch

The honest list of open questions is longer than the list of settled ones.

It is not settled whether Treasury will grandfather PTET deductions taken in reliance on current law if a future regulation disallows them. The charitable workaround regulations applied only prospectively, to contributions made after August 27, 2018. A PTET rule could cut more deeply.

It is not settled whether the § 164 deduction for an entity-level tax survives at all for a partnership whose partners are, in substance, paying the tax that their home state would have imposed on them individually. A close reading of IRC § 164(a) and its legislative history suggests yes. A close reading of the anti-abuse doctrine in Gregory v. Helvering, 293 U.S. 465 (1935), and the substance-over-form cases that follow from it, leaves room for a future challenge.

It is not settled what happens to Connecticut's own revenue. The 93.01% credit was sized to be roughly revenue-neutral, but only on static assumptions. If the Connecticut PTET draws S-corp formations that would otherwise have gone to New York or Massachusetts, Connecticut's take goes up. If the federal deduction fails to survive a future regulation, Connecticut still has the tax on the books but the pitch evaporates, and the legislature may well go back and add an election, as Wisconsin did from the start.

It is not settled how the interaction with IRC § 199A plays out. Section 199A's qualified-business-income deduction is computed at the owner level, after the entity's federal income is determined. An entity-level PTET reduces the entity's federal income, which reduces QBI, which reduces the § 199A deduction. On net, the federal benefit of the PTET is slightly smaller than the nominal 6.99% times the top federal rate would suggest, because some of that benefit is eaten back by the 199A drag. We have not seen a well-worked numerical example in any major accounting firm's publication yet; most year-end planning memos we have read in July and August 2019 gloss over this interaction.

The one thing that is settled is that the 2018 return filed in April 2019 by every Connecticut partnership and S corporation with Connecticut-source income paid 6.99% of that income to Hartford, got a federal deduction for it, and passed a 93.01% refundable credit through to the members. That happened roughly 95,000 times, and the Internal Revenue Service said nothing about any of it.

If you are forming a Connecticut entity this year, the PTET is not a decision you make. It is a fact of being an affected business entity, and the arithmetic runs in your favor. If you are forming in another state that is considering its own PTET, the question is which version of the statute the state copies. Connecticut's mandatory version generates a bigger federal deduction and a larger revenue distortion. The elective versions in Wisconsin, Oklahoma, and Louisiana let individual taxpayers pick their moment, which is cleaner for everyone and may be what Treasury ends up tolerating in a future rule. A year in, we still do not know which version the IRS prefers, because the IRS has not said.

Sources

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