“It’s one of the better workarounds out there,” said Gary Bingel, the partner-in-charge of EisnerAmper’s state and local tax group.
Alternative Method
For fund managers who earn carried interest -- typically 20 percent of a fund’s profits -- the pass-through entity tax has benefits that go beyond SALT.
Carried interest is eligible for the long-term capital gains rate of 20 percent, instead of facing ordinary income tax rates that now top out at 37 percent. (Federal law adds an additional 3.8 percent surcharge tied to Obamacare to the capital gains rate.) Under the old tax regime, assets had to be held for one year to qualify for the lower rate -- the new law sets a three-year holding period.
To compute the Connecticut levy, fund managers can use two methods. The standard way involves tallying up an entity’s income from sales and services within the state, or in the case of fund managers, annual management fees paid by investors who are Connecticut residents.
An alternative method includes any capital gains, dividends and interest earned by Connecticut residents. Managers who choose that method can include carried interest and reduce the long-term capital gains rate of 20 percent by about 1.4 percentage points, according to Bloomberg calculations supported by Michael Spiro, chair of the tax group at Finn Dixon & Herling in Stamford, and Ivan Mitev, a tax lawyer at Pillsbury Winthrop Shaw Pittman.
While people normally gripe about a new tax, the alternative method is a “good thing” and may be a net positive, Louis Schatz, a tax lawyer at Shipman & Goodwin and past chairman of the tax section of the Connecticut Bar Association, said during a June 12 webinar.
Pass-throughs have to elect to use the alternative method on or before the due date, or extended due date, of the entity’s return each year. Estimated quarterly payments were first due on June 15 for those that follow the calendar year, but Connecticut has said it will give taxpayers some flexibility to re-characterize their 2018 payments.
Tax Examples
Before the pass-through entity tax, a fund manager with $1 million in management fees would have owed Connecticut state taxes of $69,900 and federal income taxes of $370,000 assuming top individual rates, according to an example by law firm Kleinberg, Kaplan Wolff & Cohen.
With the new workaround, the manager could reduce her federal tax bill by almost $26,000. She would be able to reduce her adjusted gross income by $69,900, bringing it down to about $930,000 -- taxed at 37 percent, that’s a federal tax bill of about $344,000. And she would receive a 93 percent credit on her state tax bill for the $69,900.
In an alternate example provided by Kleinberg Kaplan, if a manager earned $1 million -- but only in carried interest -- she would save almost $14,000. That’s because a 20 percent rate applied to the $930,000 would create a tax bill of $186,000, compared to $200,000 that would have been owed on the full $1 million.