The Connecticut Department of Revenue Services released guidance this week on the recently enacted Pass-Through Entity Tax Credit, which state lawmakers approved this spring as a way to get around limits in the new federal tax law on state and local tax deductions.

Connecticut Governor Dannel Malloy signed the law at the end of May. For tax years starting after Jan. 1, 2018, a pass-through entity is now subject to a tax on its own income, known as the Pass-Through Entity Tax, instead of passing along the tax to its partners, members or shareholders, as is traditionally done with pass-through businesses. However, the law also provides a tax credit that partners can claim on their state income tax returns and corporate tax returns to ensure the entity’s income isn’t taxed twice. According to the guidance released Tuesday by the state’s tax department, a pass-through entity must report the amount of the PE Tax Credit allocated to each of its partners on Schedule CT K-1 for the year the distributive share of the PE’s income that created the tax liability is included in the partner’s income.

New York is considering offering a similar tax credit as a way around the $10,000 limit on the state and local tax deduction in the Tax Cuts and Jobs Act, the federal tax overhaul that Congress passed last December (see Some high-tax states aim to provide businesses workaround for SALT limits). But the IRS and the Treasury Department have indicated they will show little tolerance for attempts by blue states like New York, Connecticut, New Jersey and California to circumvent the new federal tax law. Last week, the IRS and the Treasury issued proposed regulations aimed at stopping states from setting up charitable contribution funds where taxpayers can make payments as if they were donations, instead of their usual state tax payments (see IRS short-circuits SALT deduction charitable workarounds to new tax law, but leaves others open for now). The IRS and Treasury could decide to do something similar for state tax credits for pass-through entities.

‘A clear and present danger’

Connecticut businesses and their tax preparers that try to take advantage of the new tax law might find themselves in trouble if the IRS and Treasury issue regulations clamping down on such tactics. Michael Knight, a partner at Knight Rolleri Sheppard CPAs LLP in Fairfield, Connecticut, believes CPAs should be advising clients against claiming the tax credit, even though the tax itself is now mandatory, and he is hoping the state CPA society will advise practitioners about what to do.

“Connecticut CPAs face a clear and present danger of aiding and abetting in tax malfeasance,” he wrote in an email last Friday to officials at the Connecticut Society of CPAs, which he shared with Accounting Today. “The state society owes us an explanation before the end of the year. If clients get audited two years down the road and incur penalties and interest, who is going to be liable? Us Connecticut CPAs. If I am wrong, it is much better for me to amend a return and get a refund, versus owing penalties.”

He believes that federal officials would disallow the tax credit on the basis of the “form over substance” doctrine.

“Connecticut is clearly trying to create a deduction which the new tax law disallows,” said Knight. “Connecticut’s proposal upends decades of tax law. A below-the-line deduction (itemized deduction of income taxes) has never been allowed as an above-the-line deduction affecting adjusted gross income. Connecticut’s proposal upends and undermines the very sacred covenant of Social Security taxes by reducing income subject to Medicare taxes. Connecticut’s excuse is other states do it. Other states do not have a quid pro quo whereby the pass-through tax reduces federal tax income.”

The new Connecticut law also includes a provision authorizing municipalities to issue residential property tax credits to eligible individual taxpayers who contribute to approved community organizations as a way of getting around the SALT deduction limits for individual taxpayers.

One official from the Connecticut Society of CPAs believes that provision isn’t likely to pass muster with the IRS, but sees a 50/50 chance for the Pass-Through Entity Tax Credit.

“The property tax measure is not expected to be upheld,” the official wrote in an email to Knight that he shared with Accounting Today. “This is primarily because of the intent factor. People would not be giving to the municipalities with the intent to benefit them or the charitable trust but instead to reduce their property taxes. The pass-through entity measure has at least a 50 percent chance of being upheld. It is a mandatory tax imposed on pass-through entities. It’s not a voluntary contribution.”