New Connecticut Tax on Pass-Through Entities — Impact on Hedge Funds and Hedge Fund Managers

On May 31, 2018, Connecticut enacted the “Act Concerning Connecticut’s Response to Federal Tax Reform”. Among other things, the Act imposes a 6.99% tax on certain pass-through entities (which, prior to the Act, were not subject to any Connecticut entity-level income tax). This tax may have significant implications for fund managers and other businesses with some Connecticut nexus, even if that nexus is limited to the presence of Connecticut partners, and may prompt restructuring of certain entities. Estimated taxes are due by June 15, 2018, although Connecticut may not impose penalties for a late first payment, due to the recent enactment of this new tax.

It can be expected that other states will enact similar taxes and such taxes will raise similar issues and tax planning opportunities.

Overview of the Tax

For calendar year taxpayers, this tax is applicable beginning January 1, 2018. In general, it is imposed at a rate of 6.99% on the taxable income of certain “business entities” – specifically, S corporations and entities classified as partnerships for federal income tax purposes. Each owner of an affected entity receives a Connecticut state personal income tax credit equal to 93.01% of his or her share of the entity tax. In the case of individual owners, this credit is refundable if it results in an overpayment of taxes. By reason of this tax credit, in some or perhaps many cases this tax will have no effect upon the aggregate Connecticut income tax imposed upon an affected entity and its owners.

In general, this tax is imposed upon an affected entity’s Connecticut source income, although (as discussed below) there is an election to use an alternative tax base.

Example 1: for a Connecticut-based entity earning a management fee entirely allocable to Connecticut, this tax applies to its net management fee income.

Example 2: in the case of a Connecticut-based entity earning a “carry” from a typical long/short hedge fund, none of the entity’s income would be considered Connecticut-source, and thus (under the general rule) none of its income would be subject to this tax. However, an affected entity may elect to use an alternative tax base, equal to (1) the percentage interest of its Connecticut resident owners, multiplied by (2) its income (regardless as to source). This election must generally be made by the due date, including extensions, of the applicable tax return. Thus, assuming that 75% of the entity is owned by Connecticut residents, 75% of the entity’s income would be subject to this tax if it elects the alternative base.

Example 3: in the case of a typical domestic long/short hedge fund, none of the fund’s income would be Connecticut source and therefore none of its income would be subject to this tax. Similar to Example 2, the fund could make an election to pay Connecticut tax with respect to income allocable to Connecticut residents. This would be favorable for Connecticut tax residents. A manager would want to consider, among other things, the allocation of this cost among its investors and whether this tax would negatively affect its carry. Query, whether a fund that is not managed in Connecticut could make this election.

As a tax on a “business entity”, this tax is intended to have the effect of being deductible for federal income tax purposes. In IRS Notice 2018-54, the IRS stated that it may not respect various state efforts to bypass the new limitations upon the deductibility of state and local personal taxes. It is not clear whether the IRS will challenge the deductibility of this new Connecticut tax, or what basis it would have for doing so. (Query whether certain aspects of this tax may provide a basis for the IRS to challenge its deductibility.)

In certain cases this tax could increase the overall SALT (state and local tax) imposed on an affected business entity and its owners. For example, a New York State resident owner will incur New York State personal income tax on his or her share of the taxable income of the entity, without any offset for the Connecticut tax credit flowing from the entity. Thus, absent action by New York State, such an owner will generally bear the cost of this new tax. In addition, while the Connecticut entity-level tax is offset by any “similar tax” imposed by another state upon income from such state, there may be questions as to whether a tax is “similar” and as to the calculation of such offset. Finally, there are limitations upon a corporate member’s ability to utilize the Connecticut tax credit flowing from the entity.

Example of Potential Tax Benefit

Assume that a Connecticut-based manager has $1,000,000 of net management fee income, all earned through a wholly-owned S corporation (or partnership), and assume that tax is imposed at the highest applicable marginal income tax rates. But for the new Connecticut tax, the manager’s Connecticut and federal personal income taxes would be $69,900 and $370,000, respectively, for a total of $439,900. Due to this tax, the Connecticut income tax imposed on the S corporation would be $69,900, and the Connecticut and federal personal income taxes imposed on the manager would be $0 ($65,014 less an equal credit) and $344,137, respectively, for a total of $414,037. Thus, the manager’s federal income tax savings are $25,863.

Ultimately, the amount of federal income tax savings depends on the character of the underlying income. For example, if the $1,000,000 of taxable income in the example above is all long-term capital gain, then the tax savings is reduced to $13,980.

Estimated Taxes

The new tax requires estimated taxes to be paid during the taxable year. The first estimated tax payment of such tax is due by June 15, 2018. Since the tax was only recently enacted, it would appear that Connecticut will not be strict regarding the timing of the first payment. Connecticut has issued a notice (SN 2018(4)) on the payment of estimated taxes.

Structural Considerations

Notably, this new tax applies to any entity treated as a partnership for federal tax purposes, but not to disregarded entities (such as an LLC with a single owner). In some investment management company structures, the investment manager (which earns the management fee) is classified as a partnership for federal income tax purposes, but the general partner (which earns the incentive allocation) is a single-member LLC and classified as a disregarded entity. The new Connecticut income tax would not apply to such a general partner entity. Any Connecticut-based manager should consider converting such a general partner entity to either a partnership (by adding a second member, such as a spouse) or an S corporation, in order to obtain the benefit of this new tax for income flowing through that entity. Such an entity may also have to elect the alternative tax base described above to obtain such benefits.

Of course, while it is expected that such a restructuring may produce a federal income tax benefit (as described above), it involves some risk, including the possibility of double state taxation (if any of the owners of the affected entity are not Connecticut residents) or that the IRS successfully asserts that the new Connecticut tax is not deductible for federal income tax purposes.