Hedge fund and private equity managers in Connecticut may have more to like about the state’s novel workaround for a new cap on state and local tax deductions.
Not only do those who live and work in the state get a break on their property taxes, they can also shave the tax bill for their carried interest profits, a key source of earnings.
Earlier this year, Governor Dannel Malloy signed a law that creates a way for owners of so-called pass-through businesses, such as partnerships, to take bigger federal deductions to absorb the hit from the tax law’s new $10,000 SALT deduction limit. Buried in the provision is a way to further reduce the rate applied to carried interest.
For managers at some of Connecticut’s big funds such as Viking Global Investors, Lone Pine Capital, Stone Point Capital and Silver Point Capital, the measure could translate to hundreds of thousands, or even millions, of dollars in federal tax savings on carried interest. Representatives for the firms didn’t respond to requests for comment.
The new tax “could create a significant benefit,” said Joseph Pacello, a tax partner in the asset management group at BDO USA. Pacello said the carried interest break is currently being discussed by fund managers in Connecticut and their accountants.
President Donald Trump’s tax overhaul created a $10,000 cap on state and local tax deductions, a pittance for taxpayers in Northeastern states that have high property taxes. Connecticut taxpayers will see an additional $2.8 billion federal income tax liability as a result of the SALT cap in 2018, the state’s estimates show.
Democratic governors in high-tax states, including Malloy, have battled the Republican law’s cap, saying they’re being unfairly targeted, and have approved different workarounds.
Last month, the IRS moved to block the most common strategy — making charitable donations for property tax payments — but remained silent on other workarounds, like Connecticut’s pass-through entity tax.
The pass-through tax, signed into law by Malloy in May, set a mandatory 6.99 percent levy — the state’s top marginal individual income tax rate — on pass-through entities, whose income is reported on owners’ personal returns and taxed at individual rates. Pass-through owners then get a state credit equal to about 93 percent of the owner’s share of tax paid by the business. They also get a full deduction for the levy as a business expense on their individual federal returns, since those are still unlimited.
The workaround, retroactive to Jan. 1, 2018, effectively assesses a state tax on the business that the owner can turn into a federal deduction.
“It’s one of the better workarounds out there,” said Gary Bingel, the partner-in-charge of EisnerAmper’s state and local tax group.
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.
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.
Managers who are able to combine their management fees and their carried interest would be able to maximize their savings. “It behooves funds to explore this,” Spiro said.
Still, Spiro and others warn the IRS could issue regulations curbing the pass-through workaround, and any associated carried interest breaks. The agency could say that carried interest can’t be included when calculating the pass-through entity tax, or that carried interest isn’t a deductible business expense.
‘Appetite for Risk’
Not all funds will be able to take advantage of the pass-through tax. Single-member LLCs aren’t considered pass-throughs, so for managers who keep their carried interest profits in such a vehicle, the workaround is off limits.
Those managers could add a member, such as a spouse, or switch to become an S corporation to obtain the carried interest benefit of the new tax, according to a June 12 note from Kleinberg Kaplan.
Mitev cautioned such moves are “for people who have greater appetite for risk.” Still, if they get slapped with a 20 percent IRS penalty for underpayment, “they could have a good argument that they’re just following state law,” he said.
Managers who work in Connecticut but live in New York are likely to be shut out of the full savings from the pass-through entity tax.
While the fund would pay the mandatory Connecticut levy, and the New York resident would be eligible to take it as a federal deduction, he wouldn’t get a corresponding credit on his New York state income tax return, according to Mitev.
“If you’re a New York resident, you are hosed in a way,” Mitev said.
— With assistance from Katherine Burton, Krista Gmelich, Miles Weiss and Heather Perlberg