The Internal Revenue Service (IRS) released Notice 2020-75 on November 9, 2020, which validates the federal income tax deductibility of the payment of the Connecticut Pass-Through Entity Tax (the “PET”).

The 2017 Tax Cuts and Jobs Act limited the deduction of state and local income taxes to $10,000 for tax years 2018 and thereafter. In response, the Connecticut legislature adopted a 6.99% tax on each partnership, limited liability company and S Corporation conducting business in Connecticut. This tax was coupled with a Connecticut income tax credit for the owners of the entity, which provided each owner with a pro rata share of the PET deduction, so that the income earned by the entity was taxed only once.

The limitation on deducting more than $10,000 of state and local taxes is a limitation imposed on each individual taxpayer. The PET is a tax imposed on a pass-through entity and was designed so that it would not be subject to this limitation. The question was whether the IRS would attempt to limit the entity’s deduction, and thereby limit the deduction of the pass-through owner. Notice 2020-75 clarifies that the full deduction is available to the entity and that it may be fully passed through to the entity’s partners, members or stockholders. 

The net effect of the PET is that each owner of a pass-through entity may deduct for federal income tax purposes substantially all of the Connecticut income tax which would have been payable by the owner prior to the enactment of the PET and which is now being paid by the pass-through entity.

In other words, the Connecticut legislature successfully provided a work-around to the SALT (State and Local Tax) limitations enacted by Congress.

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