The Connecticut Pass Through Entity Tax
The Connecticut Pass through Entity Tax, hereafter abbreviated CTPE tax, is one of the least intuitive pieces of legislation our office has ever encountered. In this article we’re going to walk you through how the CTPE tax works, and why, surprisingly, you may want to restructure your business in order to make it subject to the CTPE Tax.
Please note: information on this page is simplified. I do not include the deductible part of self employment taxes, that self employment taxes are taxed at 92.35% of total SE income, or the Qualified Business Income Deduction (QBI) in any illustrations. Therefore, when I am discussing taxable income I am discussing a simplified taxable income as if these elements did not exist.
These factors are included in the final tax calculation in the comprehensive example. I leave them out of my explanation in order to focus on the items that the CTPE tax directly impacts.
Standard deductions, itemized deductions
To understand how the CTPE tax works you need to understand the difference between the standard deduction and itemized deductions on a tax return.
Itemized deductions
Let’s start with itemized deductions and a simplified version of how a tax return works: First, a tax return adds up all the money you made in a year from every source. That’s called Adjusted Gross Income. Then, you subtract out all the money you spent in certain categories. The most common categories that you are allowed to deduct (subtract) are:
Mortgage interest
Charitable donations
State and Local Taxes (including real estate taxes on your house, personal property taxes on your car, and income taxes from your state return.)
In a simplified example, let’s say you made $50 from your ice cream stand and you gave a $10 donation to an animal shelter and paid $10 on your state income tax return. You have an Adjusted Gross Income of $50, you subtract $10+10 in itemized deductions, and you arrive at $30. In this scenario you would be taxed on $30 for that year.
Standard deduction
Tracking your itemized deductions and adding them all up every year can be very time consuming. To make things simpler, you can take the standard deduction. This is an amount set each year that any tax payer can deduct from their Adjusted Gross Income instead of taking itemized deductions. Let’s say that the standard deduction in our simplified example was $45. Now you get a choice as a taxpayer:
Itemize vs Standard
Do you want to itemize your deductions and get the following result:
$50-itemized deductions of $20= $30 taxable income
Or, do you want to take the standard deduction and get the following result:
$50-standard deduction of $45= $5 taxable income
Standard deduction is better right? So the takeaway here is that you itemize deductions only if your itemized deductions are higher than the standard deduction that year.
Tax Cuts and Jobs Act- State and Local Taxes Capped at 10k
Remember how I said that one of the itemized deductions was state and local taxes? The Tax Cuts and Jobs Act of 2017 added a caveat to that deduction, now you can only deduct up to $10k in state and local taxes. So consider the hypothetical situation of “Connor,” an unmarried Connecticut taxpayer who owns a business that made $100k:
Connor paid real estate taxes on his home of of $2,500 in July and $2,500 on December 31st.
Connor paid $15k in Connecticut state income taxes throughout the year through estimated payments
Real estate taxes and income taxes added together = $20k
Connor had no mortgage interest and made no charitable donations.
The standard deduction in 2019 was $12,200 for a single tax payer. Connor’s itemized deductions are $20k. So prior to the tax cuts and jobs act here’s how Connor’s options would have looked:
Connor Itemizes his deductions:
$100k - itemized deductions of $20k= Taxable income of $80,000
Connor takes the standard deduction:
$100k - standard deduction of $12,200 = Taxable income of $87,800
Connor should itemize right? Well because of the Tax Cuts and Jobs Act he can’t deduct any more than 10k in state and local taxes. That means the actual equation is this:
Connor Itemizes his deductions:
$100k - itemized deductions of $10k= Taxable income of $90,000
Connor takes the standard deduction:
$100k - standard deduction of $12,200 = $87,800
Now Connor should take the standard deduction, and instead of taxable income of $80,000 he has taxable income of $87,800.
Bummer. However……CTPE tax to the rescue!
CTPE Tax
The CTPE tax is a way around 10k State and Local Taxes cap. Here’s how it works:
Step one: form a pass through entity that is not a disregarded entity.
You’re probably familiar with the most popular form of pass through entity: The Limited Liability Company (LLC). Other examples include S Corps, General Partnerships, Limited Liability Partnerships, and Limited Liability Limited Partnerships. We’ll confine our discussion to LLCs.
If you already have an LLC with only one member, you are what is called a disregarded entity, and the CTPE tax won’t help you. You’ll need to add a partner to your business to be eligible; many taxpayers add their spouses as partners to take advantage of this law.
Your LLC is now a separate business. Conceptually imagine that now instead of you earning money, paying expenses and keeping the profit, your LLC earns money and pays expenses, and then pays you the profit. Keep this slight difference in mind.
Step two(automatic):
Your LLC is now subject to the CTPE tax. You must now make CTPE estimated tax payments every quarter through the CT website.
Step three
Connecticut gives you back (most) of the CTPE taxes when you file your Connecticut income tax return.
Now, let’s return to the example of Connor:
Comprehensive example
We’re going to examine the differences between the first scenario we talked about with no LLC and no CTPE tax, we’re going to call that original. We’ll compare it to the version with LLC and CTPE, we’ll call that With CTPE. (For the purposes of this example assume that Connor added his nephew as a 1% partner in the LLC in order to be subject to the CTPE tax. That 1% share will be left out of tax calculations for simplicity)
Original (same as above)
Income $100k, standard deduction of $12,200 (because state and local taxes are capped) = Taxable income of $87,800
With CTPE
LLC makes $100k
LLC pays CTPE taxes of 6.99% each quarter, for a total of $6,990 by the end of the year
LLC pays Connor $100k-$6,990 = $93,010
Income $93,010, standard deduction of $12,200 = taxable income of $80,810.
How big a difference does that make?
Original produces federal self employment taxes of $14,300 and federal regular income taxes of $10,065 Total: $24,195
With CTPE produces federal self employment taxes $13,142 of and federal regular income taxes of $$8,921 Total: $22,063
With CTPE federal savings: $2,132.
Those savings would repeat year after year.
Costs
You need to consider three costs in deciding whether to pursue using the CTPE tax as a tax mitigation strategy.
If you hire an accounting firm like ours to help you take advantage of the CTPE tax you’ll be paying our hourly rate or a flat fee for that help.
Going forwards you’ll need to file 2 tax returns every year. A tax return for your LLC, and your normal, personal tax return. Most accounting firms, ours included, charge by return. That means your tax preparation fees will go up.
The CTPE tax is 6.99%, this rate is designed to be higher than the taxes you would otherwise have paid on your CT return. CT gives you a refundable credit (gives you the money back) when you file your personal return but they don’t give back all of it. They give back 87.5% of the tax you paid. For most tax payers that results in an increase to their Connecticut taxes. To use our examples above:
Original Connor would have paid $4,821 in CT income taxes
With CTPE
$6,990 in CTPE tax is paid by the LLC
Connor gets credit back for 87.5% on his CT personal return= $6,116
Results in a refund of $1,693
Net CT taxes paid ($6,990-$1,693)= $5,297
Increase due to CTPE( $5,297-$4,821)= $476
Net savings from using the CTPE= Federal savings $2,132 minus CT costs $476= $1,656.
Is it worth it?
That’s up to you. This very complicated tax is a net benefit to most small business owners. However, you should know that Connecticut has already reduced the tax credit for the CTPE tax once, originally the refundable credit was for 93% of the CTPE tax, now it’s 87.5%. Every time Connecticut reduces this amount they effectively raise CTPE taxes and make taking advantage of the law less valuable. Also, many accounting firms, ours included, have more stringent requirements for the financial records that support partnership tax returns. So if your accounting system is currently notes on the back of a napkin, you may need to invest in accounting software and learn to use it. Our office provides consultation services on all accounting software, with a specialty in Intuit Quickbooks.
I want to learn more, what should I do?
Contact our office via the information at the bottom of all pages of this website. We’ll take a look at your situation and give you a quote for our help walking you through this process. If you are not an existing client, we’ll need your most recently filed tax returns in order to advise you, so please gather those prior to contacting us.