When Connecticut municipal-bond interest flows through a partnership 'Portfolio' and then a mutual fund to an individual, does it stay exempt from Connecticut income tax?

Plain-English summary

This is the individual/trust income-tax companion to Ruling 99-5. The same master-feeder fund structure is involved: a Massachusetts trust sets up "Portfolios" — sub-trusts treated as partnerships for tax purposes — and one of them (the "Connecticut Portfolio") invests in Connecticut municipal bonds (and U.S.-territory bonds like Puerto Rico, Guam and the Virgin Islands, which federal law bars states from taxing). Regulated investment companies (mutual funds) invest in that Portfolio and then pay exempt-interest dividends to their own shareholders. The question: when Connecticut-bond interest travels through the partnership Portfolio → mutual fund → individual (or trust/estate) investor, does it keep its Connecticut-exempt character all the way down?

DRS said yes — the character survives every layer:

• Character passes through the partnership. A partnership isn't itself taxed; its items keep their character in the partners' hands. Under Conn. Agencies Regs. § 12-715(b)-1(a), a partnership item that isn't taken into account federally (like interest on another government's bonds) keeps the same character for a partner as if the partner had realized it directly. So the Connecticut Portfolio's Connecticut-bond interest retains its character as Connecticut-bond interest in the hands of a mutual-fund Investor.
• Individual shareholders don't add it back. Connecticut income tax starts from federal adjusted gross income, then applies modifications. The add-back in Conn. Gen. Stat. § 12-701(a)(20)(A)(ii) covers exempt-interest dividends but expressly excludes those derived from Connecticut obligations (and from obligations federal law protects from state taxation). Because the dividends trace to Connecticut/territory bonds, an individual shareholder is not required to add them back into Connecticut adjusted gross income.
• Trust and estate shareholders get the same result. A parallel rule (§ 12-701(a)(10)(A)(ii)) means a trust or estate shareholder does not take those dividends into account in computing the Connecticut fiduciary adjustment.

DRS noted this matches how other states treated the same kind of pass-through — citing Massachusetts Letter Ruling 93-12, South Carolina Private Letter Ruling 93-8, and New York's advisory opinion TSB-A-91(11)I — and that the IRS had issued no Revenue Ruling on the point.

What this means for you

Individual investors in Connecticut municipal-bond funds

If you hold a Connecticut muni-bond mutual fund — even one built on a master-feeder or fund-of-funds design with an intermediate partnership layer — the Connecticut-bond portion of your exempt-interest dividends stays exempt from Connecticut income tax: you don't add it back on your Connecticut return. You rely on the fund's reporting to identify the Connecticut/territory-sourced portion.

Trusts, estates and fiduciaries

The same protection applies through the Connecticut fiduciary adjustment: a trust or estate holding such a fund doesn't pull the Connecticut-bond exempt-interest dividends into the fiduciary adjustment, and the benefit ultimately flows to individual beneficiaries.

Mutual-fund companies, advisers, accountants and tax professionals

The pass-through rests on three joints: partnership character retention (Reg. § 12-715(b)-1(a)), the individual add-back exception for Connecticut/federally-protected obligations (§ 12-701(a)(20)(A)(ii)), and the parallel fiduciary-adjustment rule (§ 12-701(a)(10)(A)(ii)). Structure shareholder reporting to identify the Connecticut/territory-sourced portion at each tier. Note the companion corporation-business-tax analysis in Ruling 99-5, and that DRS aligned with Massachusetts, South Carolina and New York guidance on the same question.

Common questions

Q: Does Connecticut municipal-bond interest stay exempt when it passes through a partnership portfolio and a mutual fund?
A: Yes. The interest keeps its Connecticut-bond character through the partnership and the fund, so individual shareholders don't add the resulting exempt-interest dividends back into Connecticut adjusted gross income.

Q: What about out-of-state municipal bonds?
A: The exception is specific to Connecticut obligations and obligations federal law protects from state taxation (e.g., Puerto Rico, Guam, Virgin Islands). Dividends traceable to other states' bonds are generally added back.

Q: How are trusts and estates treated?
A: The same way, through a parallel rule — the Connecticut-bond exempt-interest dividends aren't taken into account in the Connecticut fiduciary adjustment (§ 12-701(a)(10)(A)(ii)).

Q: Is there a companion ruling for funds themselves?
A: Yes. Ruling 99-5 addresses the corporation-business-tax side — a regulated investment company's deduction for exempt-interest dividends — arising from the same master-feeder structure.

Citations and references

Statutes:

• Conn. Gen. Stat. § 12-700 (Connecticut income tax on individuals, trusts and estates)
• Conn. Gen. Stat. § 12-701(a)(19)–(20), (a)(20)(A)(ii) (Connecticut AGI; add-back of exempt-interest dividends excepting Connecticut/federally-protected obligations)
• Conn. Gen. Stat. § 12-701(a)(9)–(10), (a)(10)(A)(ii); §§ 12-714, 12-716 (Connecticut fiduciary adjustment and beneficiary shares)

Regulations and federal law:

• Conn. Agencies Regs. § 12-715(b)-1(a) (partnership items retain federal character); § 12-701(a)(20)-5(a); § 12-701(b)-1(a)(3)
• 26 U.S.C. § 852(b)(5) (exempt-interest dividends); § 103(a) (state or local bond interest excluded); § 851 (RIC); § 7701(a)(2) & § 7704 (entity classification / publicly traded partnerships)

Other-state guidance cited:

• Massachusetts Letter Ruling 93-12; South Carolina Private Letter Ruling 93-8; New York TSB-A-91(11)I
• Companion ruling: Ruling 99-5 (corporation-business-tax treatment of the same structure)

Source

• Landing page: Connecticut DRS Rulings
• Ruling: Ruling 99-4

Original ruling text

Ruling 99-4, Income Tax

FACTS:

A trust that is established under the laws of the Commonwealth of Massachusetts ("the Trust") is registered as an open-end management investment company under the Investment Company Act of 1940, as amended ( endnote 1 ). The Trust itself is not open to investment. Rather, it establishes sub-trusts ("Portfolios") in which investments may be made.

Investors in Portfolios ("Investors") will be regulated investment companies, as defined in 26 U.S.C. §851, bank common trust funds, endowments and other institutional investors but will not include individuals, S corporations, partnerships, limited liability companies or grantor trusts. Each Portfolio is, for federal income tax purposes, a separate taxable entity which will hold for the benefit of its Investors marketable securities and cash, and the assets of each Portfolio will be separate and distinct from those of each other Portfolio.

Each Portfolio, although nominally a trust under state law, is an association for purposes of 26 U.S.C. §7701(a)(2) and the regulations thereunder, and will be classified for federal income tax purposes as a partnership. Each Portfolio will maintain capital accounts and allocate items of income and expense in accordance with subchapter K of the Internal Revenue Code  ( endnote 2 .  A Portfolio may not make a distribution prohibited under Rev. Rul. 89-81, 1989-1 C.B. 226, and will not be treated as a publicly traded partnership under 26 U.S.C. §7704.

Certain of the Portfolios will invest in State or local bonds ("the State or Local Bonds"), as defined in 26 U.S.C. §103(c)(1) ( endnote 3 ), the interest income from which is excluded from gross income under 26 U.S.C. §103(a). A Portfolio’s distribution to an Investor, to the extent properly allocable to interest income received or accrued by the Trust in respect of the State or Local Bonds, will be excludible from the Investor’s income under 26 U.S.C. §103(a). Payment by an Investor that is a regulated investment company of a dividend to a regulated investment company shareholder will, to the extent properly allocable to interest income received or accrued by the Investor in respect of the State or Local Bonds, be an exempt-interest dividend, as defined in 26 U.S.C. §852(b)(5)  ( endnote 4 ).

One of the Portfolios (hereinafter, the "Connecticut Portfolio") will invest in State or Local Bonds that are issued by or on behalf of the state of Connecticut, its political subdivision, or public instrumentality, state or local authority, district or similar public entity created under the laws of the state of Connecticut or in State or Local Bonds that are issued by or on behalf of a territory or possession of the United States (such as Puerto Rico, Guam or the Virgin Islands), the taxation of which by any state is prohibited by federal law ( endnote 5 ). (The State or Local Bonds in which the Connecticut Portfolio will invest are hereinafter collectively and individually referred to as "the Connecticut State or Local Bonds.")

ISSUES:

Whether the Connecticut Portfolio’s interest income derived from the Connecticut State or Local Bonds retains in the hands of an Investor its character as interest income derived from the Connecticut State or Local Bonds.

Whether, in the case of an Investor that is a regulated investment company, a distribution by the Investor, to a shareholder who is an individual, of exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), that are derived from interest income properly allocable to the Connecticut State or Local Bonds is required to be added to the shareholder’s federal adjusted gross income in computing his or her Connecticut adjusted gross income.

Whether, in the case of an investor that is a regulated investment company, a distribution by the investor, to a shareholder which is a trust or estate, of exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), that are derived from interest income properly allocable to the Connecticut State or Local Bonds is required to be taken into account in computing the Connecticut fiduciary adjustment.

DISCUSSION:

Chapter 229 of the Connecticut General Statutes imposes an income tax on individuals, trusts and estates. Conn. Gen. Stat. §12-700. "A partnership as such is not subject to income tax. Individuals carrying on business as partners are liable for the income tax only in their individual capacities on their respective distributive shares of partnership income, whether or not such shares are actually distributed to them." Conn. Agencies Regs. §12-701(a)(20)-5(a). Any entity that is a partnership for federal income tax purposes (such as the Connecticut Portfolio) is a partnership for Connecticut income tax purposes. Conn. Gen. Stat. §12-701(a)(33); Conn. Agencies Regs. §12-701(b)-1(a)(3).

The starting point in computing the Connecticut adjusted gross income, as defined in Conn. Gen. Stat. §12-701(a)(20), of a resident individual is the individual’s federal adjusted gross income. Conn. Gen. Stat. §12-701(a)(19). The starting point in computing the Connecticut taxable income, as defined in Conn. Gen. Stat. §12-701(a)(10), of a resident trust or estate, is the trust or estate’s federal taxable income. To an individual’s federal adjusted gross income, there is added or subtracted the modifications enumerated in Conn. Gen. Stat. §12-701(a)(20)  ( endnote 6 ). To the trust or estate’s federal taxable income is added or subtracted the share of the trust or estate in the modifications enumerated in Conn. Gen. Stat. §12-701(a)(10) (the Connecticut fiduciary adjustment)  ( endnote 7 ) .

Conn. Gen. Stat. §12-701(a)(20)(A)(ii) provides that there shall be added to an individual’s federal adjusted gross income,

(ii) any exempt-interest dividends, as defined in Section 852(b)(5) of the Internal Revenue Code, exclusive of such exempt-interest dividends derived from obligations issued by or on behalf of the state of Connecticut, any political subdivision thereof, or public instrumentality, state or local authority, district or similar public entity created under the laws of the state of Connecticut and exclusive of such exempt-interest dividends derived from obligations, the income with respect to which taxation by any state is prohibited by federal law ...  ( endnote 8 )

A similar amount is required to be taken into account pursuant to Conn. Gen. Stat. §12-701(a)(10)(A)(ii) in computing the Connecticut fiduciary adjustment ( endnote 9 ). The share of a trust or estate, as determined under Conn. Gen. Stat. §12-716 ( endnote 10 ), in the Connecticut fiduciary adjustment is added to or subtracted from, as the case may be, the federal taxable income of the fiduciary of such trust or estate  ( endnote 11 ).

Turning now to the issue of whether a partnership’s interest income derived from the Connecticut State or Local Bonds retains in the hands of its partner its character as interest income derived from the Connecticut State or Local Bonds, Conn. Agencies Regs. §12-715(b)-1(a) provides that partnership items of income, gain, loss or deduction "shall have the same character for a partner for Connecticut income tax purposes as for federal income tax purposes. Where an item is not characterized for federal income tax purposes, the item shall have the same character for a partner as if realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership. If a partnership item is not required to be taken into account for federal income tax purposes (such as interest on bonds of another state), the character of the item for a partner for Connecticut income tax purposes is the same as if the partner, as an individual, had realized or incurred the item directly." Accordingly, because the Connecticut Portfolio’s interest income derived from the Connecticut State or Local Bonds is not required to be taken into account for federal income tax purposes, such income retains in the hands of an Investor its character as interest income derived from Connecticut State or Local Bonds as if the Investor had realized the item directly.

Because the interest income derived from the Connecticut State or Local Bonds retains in the hands of an Investor in the Connecticut Portfolio its character as interest income derived from Connecticut State or Local Bonds as if realized directly by the Investor, and because payment by an Investor that is a regulated investment company of a dividend to a regulated investment company shareholder will, to the extent properly allocable to interest income received or accrued by the Investor in respect of the State or Local Bonds, be an exempt-interest dividend, as defined in 26 U.S.C. §852(b)(5), a distribution by an Investor that is a regulated investment company, to a shareholder who is an individual, of exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), that are derived from interest income properly allocable to the Connecticut State or Local Bonds is not required to be added to the shareholder’s federal adjusted gross income in computing his or her Connecticut adjusted gross income. Conn. Gen. Stat. §12-701(a)(20)(A)(ii)  ( endnote 12 ). A comparable rule applies with respect to any shareholder which is a trust or estate: a distribution by an Investor that is a regulated investment company, to a shareholder which is a trust or estate, of exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), that are derived from interest income properly allocable to the Connecticut State or Local Bonds is not required to be taken into account in computing the Connecticut fiduciary adjustment. Conn. Gen. Stat. §12-701(a)(9)(A) and (10)(A)(ii).

RULING:

The Connecticut Portfolio’s interest income derived from the Connecticut State or Local Bonds will retain in the hands of an Investor its character as interest income that is derived from the Connecticut State or Local Bonds.

In the case of an Investor that is a regulated investment company, a distribution by the Investor, to a shareholder who is an individual, of exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), that are derived from interest income properly allocable to the Connecticut State or Local Bonds is not required to be added to such shareholder’s federal adjusted gross income in computing his or her Connecticut adjusted gross income.

In the case of an Investor that is a regulated investment company, a distribution by the Investor, to a shareholder which is a trust or estate, of exempt-interest dividends, as defined in 26 U.S.C. §852(b)(5), that are derived from interest income properly allocable to the Connecticut State or Local Bonds is not required to be taken into account in computing the Connecticut fiduciary adjustment.

Endnotes:

15 U.S.C. §80a-1 to 15 U.S.C. §80-b-2.

26 U.S.C. §701 to 26 U.S.C. §777.

Also see 26 C.F.R. §1.103-1(a) which provides generally that "[interest upon obligations of a State, territory, a possession of the United States, the District of Columbia, or any political subdivision thereof (hereinafter collectively or individually referred to as "State or local governmental unit") is not includable in gross income.

"An exempt-interest dividend shall be treated by the shareholders for all purposes of this subtitle as an item of interest excludable from gross income under section 103(a)..." 26 U.S.C. §852(b)(5)(B).

See 48 U.S.C. §§745, 1423a and 1574(b)(ii), respectively.

These modifications are described in greater detail in Conn. Agencies Regs. §§12-701(a)(20)-2 and 12-701(a)(20)-3.

These modifications are described in greater detail in Conn. Agencies Regs. §§12-701(a)(10)-2 and 12-701(a)(10)-3.

See also Conn. Agencies Regs. §12-701(a)(20)-2(a)(2).

See also Conn. Agencies Regs. §12-701(a)(10)-2(a)(2).

See also Conn. Agencies Regs. §§12-716(a)-1 and 12-716(b)-1.

Conn. Gen. Stat. §12-701(a)(9). Where the beneficiary of the trust or estate is an individual, the share of the beneficiary, as determined under Conn. Gen. Stat. §12-714, in the Connecticut fiduciary adjustment is added to or subtracted from, as the case may be, the beneficiary’s federal adjusted gross income in computing his or her Connecticut adjusted gross income. Conn. Gen. Stat. §12-701(a)(20). See also Conn. Agencies Regs. §§12-714(a)-1 and 12-714(a)-2.

The Massachusetts Department of Revenue has taken the same approach. Letter Ruling 93-12 (Aug. 3, 1993), [Mass.] St. Tax Rep. (CCH) ¶400-121. So has the South Carolina Department of Revenue and Taxation. Private Letter Ruling 93-8 (Dec. 13, 1993), [S.C.] St. Tax Rep. (CCH) ¶320-011. In an Advisory Opinion, the New York Department of Taxation and Finance has taken a similar approach with respect to exempt-interest dividends paid by a regulated investment company that was itself the shareholder of another regulated investment company that owned New York state and local bonds, the interest income from which was excluded from gross income under 26 U.S.C. §103(a). TSB-A-91(11)I (Dec. 30, 1991) [N.Y.] St. Tax Rep. (CCH) ¶400-309. No Revenue Ruling has been issued by the Internal Revenue Service.

LEGAL DIVISION

Issued September 2, 1999