Editor: Harlan J. Kwiatek, CPA, J.D., LL.M.
Time and again we hear how small businesses drive the U.S. economy. According to a 2009 report by the Small Business Administration Office of Advocacy, 1 small businesses create most of the nation’s new jobs, employ about half of its private sector workforce, and provide half of its nonfarm, private real gross domestic product.
Despite their strong contribution to the nation’s economy, small businesses face significant challenges in the current economic climate in a number of areas, not the least of which is the ability to access capital in a difficult financial market. In addition, small businesses face difficulties obtaining affordable health insurance and hiring and retaining a qualified workforce. Small businesses also cite taxes and regulatory policies as significant challenges to their success.
The issues of taxes and regulation—from a state perspective—may often be overlooked in structuring small businesses, many of which are organized as passthrough entities, such as partnerships, limited liability companies (LLCs), and S corporations. 2 State taxation of passthrough entities and their owners varies widely, with rules often dependent upon the type of entity involved and differing markedly from state to state and from a federal perspective. As a result, entities and their owners may face substantially different tax consequences based on their organizational structure, business operations, types of income, tax elections, and states in which they operate. In addition, state rules that impose compliance obligations on passthrough entities and their owners, even where a connection with a state may be limited, lead to burdensome reporting requirements that may trip up even the most well-intentioned business owners and advisers.
The move by a number of states toward mandatory withholding or estimated tax payment requirements by passthrough entities further complicates an already challenging tax regime. The adoption of hybrid tax structures such as those adopted in Ohio with the commercial activities tax, Michigan with the business tax, and Texas with the margin tax expand the reach of state tax laws to entities previously not subject to entity-level taxes. Given the potential of significant penalties as a result of the failure to comply with tax reporting obligations, business owners and their advisers should become familiar with the state and local laws, regulations, and policies that apply to passthrough entities. The above concerns are important considerations whether a passthrough entity is currently doing business outside its home state or is seeking to expand its geographic footprint.
This column highlights areas of concern regarding the taxation of passthrough entities, including entity classification, conformity to federal tax conduit treatment, and tax reporting obligations. Because this item does not provide guidance on specific state rules, passthrough entity owners and their advisers are directed to seek out clear and specific guidance regarding the taxation of passthrough entities in the states of concern.
Determining state conformity to the federal entity classification is an important first step in understanding the potential state tax aspects of passthrough entities and their owners. In general, states automatically conform to the federal entity classification of partnerships, S corporations, LLCs, and limited liability partnerships (LLPs); however, there are differences.
For example, Arkansas follows the federal S corporation election, but that election and shareholder consents must be filed with the Arkansas director of the Department of Finance and Administration in the same manner and at the same time as required for federal tax purposes for the election to apply for state tax purposes. 3 If a corporation fails to make a state election as required by law, it will be treated as a C corporation. In addition, failure on the part of nonresident shareholders to timely file Arkansas personal income tax returns reporting tax due on their distributive share of income will result in revocation of the S corporation election.
Georgia conforms to the federal S corporation election only if all stockholders are subject to tax in Georgia on their portion of corporate income or if all nonresident stockholders pay Georgia income tax on their portion of corporate income. 4 New Jersey requires that a state-specific election (Form CBT-2553, New Jersey S Corporation or New Jersey QSSS Election) be filed with the Division of Taxation within one calendar month of the allowable federal S corporation election date. 5 New York has a similar state-specific S corporation election requirement. That election, made by timely filing Form CT-6, Election by a Federal S Corporation to Be Treated as a New York S Corporation, is valid only if:
- The corporation is a federal S corporation;
- It is subject to tax under Article 9-A or Article 32 of the tax law; and
- All the corporation’s shareholders consent to the New York S election. 6
Pennsylvania allows a federally electing S corporation to opt out of state S corporation treatment provided 100% of the corporation’s shares consent on the day the election is made. 7 Tennessee does not adopt the federal S corporation provisions and requires S corporations doing business in the state to file excise tax returns and pay tax as if an S corporation election had not been made at the federal level. 8 Corporations that have already elected S corporation status for federal and other state purposes that expand into new states should determine if and when additional, state-specific elections are required to avoid missed election deadlines.
Federal income tax provisions dealing with LLCs under the federal check-the-box regulations generally allow a qualifying LLC to elect to be taxed as a corporation, partnership, or disregarded entity. An LLC classified as a partnership for federal income tax purposes must file Form 1065, U.S. Return of Partnership Income, and allocate income or loss among the members in accordance with their respective membership interests as determined by the operating agreement. In general, the disregarded entity provisions apply in the context of a single-member LLC and provide that a single-member LLC will be disregarded as an entity separate from its owner unless it elects to be treated as a corporation.
Most states automatically adopt the federal classification of an LLC. Accordingly, an LLC treated as a partnership for federal tax purposes will be treated as a partnership at the state level; however, state-specific, entity-level taxes may apply even where an LLC is treated as a partnership or a disregarded entity. For example, passthrough entities are required to file the Michigan business tax provided the gross receipts filing threshold is met. Unlike the S corporation provisions discussed above, states generally do not require state-specific check-the-box elections; however, other reporting obligations may apply. For example, when an LLC classified as a partnership for federal tax purposes files a California LLC return, it must:
- Attach the agreement of each nonresident member to file a California return, make timely payment of all California income taxes imposed on the member with respect to the LLC’s income, and be subject to personal jurisdiction in California for purposes of the collection of income taxes, interest, and penalties imposed with respect to the LLC’s income; or
- Pay to California, on behalf of each nonresident member for whom such an agreement has not been filed, a nonconsenting nonresident withholding tax in an amount equal to the highest marginal tax rate in effect multiplied by the member’s distributive share of LLC income, reduced by the amount of any domestic nonresident withholding tax previously paid on behalf of the member. 9
New Jersey requires that LLCs, foreign LLCs, limited partnerships, or foreign limited partnerships classified as partnerships for federal tax purposes obtain the consent of their corporate owners that New Jersey has the right to tax the owners’ income derived from the LLC’s or partnership’s activities in the state. 10 An entity that fails to obtain consent from its owners must pay corporate business tax on behalf of the nonconsenting owners on each of the nonconsenting owners’ share of the entity’s New Jersey income.
Conduit or Not
In general, passthrough entities are treated as conduits for federal income tax purposes, with income tax imposed on the owner of the entity rather than on the entity itself. The income tax treatment of passthrough entities for state purposes may differ from the treatment for federal income tax purposes in significant respects. Even where the state conforms for income tax purposes, additional and/or alternative state taxes such as franchise, net worth, or capital stock taxes may be imposed at the entity level. Just as important, given the challenges states may face in ensuring compliance with state tax laws of nonresident individuals, a number of states have adopted laws and regulations that require passthrough entities to withhold and remit income taxes for the distributive share of entity income attributable to nonresident owners.
In general, states do not impose an entity-level income tax on partnerships; however, Illinois imposes an income-based replacement tax on partnership income. 11 Similarly, the District of Columbia imposes a franchise tax on the net income of most passthrough entities with gross income in excess of $12,000. 12 However, entities that conduct a trade or business in which more than 80% of the gross income is derived from the personal services actually rendered by the individuals or members of the passthrough entity in the conduct or carrying on of a trade or business, and in which capital is not a material income-producing factor, are not subject to the DC franchise tax. New Hampshire imposes an entity-level business profits tax on most business entities, including passthrough entities with gross business income in excess of a stated threshold. 13
While California generally conforms to the federal tax treatment of S corporations, it imposes a 1.5% tax on California source income earned by S corporations doing business in the state. 14 Kentucky conforms to the federal income tax treatment of S corporations and allows that income will generally be passed through to the S corporation’s shareholders and taxed at the ownership level. However, a limited liability entity (LLE) tax is imposed on corporations and passthrough LLEs, including S corporations. The LLE tax is the greater of the $175 minimum tax or the lesser of a tax based on gross receipts or a tax based on gross profits. 15 Massachusetts generally conforms to the federal income tax treatment of S corporations but imposes a “sting tax” in the event S corporation gross receipts exceed stated thresholds in any year. 16 In addition, S corporations are subject to the net worth or property portion of the excise tax. 17 New York imposes a fixed dollar minimum tax on S corporations at levels that range from $25 for New York gross receipts of $100,000 or less up to $4,500 for New York gross receipts in excess of $25 million. 18
A number of jurisdictions impose entity-level taxes on LLCs. For example, Alabama imposes a business privilege tax on LLCs doing business in the state. California imposes an annual $800 minimum tax on an LLC classified as a partnership or a disregarded entity, provided the LLC is doing business in California or its articles of organization have been accepted by, or its certificate of registration has been issued by, the secretary of state. 19 In addition, California imposes a fixed dollar fee on the California-source income of LLCs classified as partnerships or disregarded entities. 20 The fee is based on the amount of California-source income earned in any tax year and ranges from $900 for California-source income of more than $250,000 but less than $500,000 up to $11,790 for California-source income in excess of $5 million. Connecticut imposes a $250 business entity tax on LLCs and LLPs. 21 New Jersey requires an LLC with income derived from New Jersey sources and more than two partners to pay a filing fee of $150 for each owner of an interest in the entity, up to a maximum of $250,000, in addition to income taxes otherwise due.
Passthrough entity owners and their advisers must be certain to address the issue of nexus and whether holding an interest in a passthrough entity creates taxable presence for the owner. For example, owning a general partnership interest in a partnership will create an income tax filing obligation for the general partner in almost all jurisdictions.
Over time, states have more aggressively pursued other passthrough owners, including those that hold a mere passive ownership interest such as interests in limited partnerships, LLCs, and LLPs. That said, some states may draw a distinction when the passthrough entity is member managed 22 as opposed to manager managed, while other states do not. 23 By way of example, New Jersey law provides that any foreign corporation that owns an interest in an LLC, manages or shares in the control of the LLC, is engaged in a single unitary business with the LLC, or is otherwise doing business in the state (under criteria set forth in New Jersey regulations) has taxable nexus in the state. 24
Unlike the rules that apply to corporate tax filers that require the filing of income tax returns only when the corporation itself has nexus in the taxing state, passthrough entities are often subject to more onerous reporting obligations. States may require a passthrough entity to file a report where the entity has a resident individual owner or corporate partner domiciled in the state as well as when the entity itself has nexus in the state. In addition, states may require the mandatory filing of composite returns as well as the withholding and payment of estimated tax on behalf of nonresident owners. For example, Maine requires a partnership, LLC, or S corporation filing federal Forms 1065 or 1120S, U.S. Income Tax Return for an S Corporation, to file a comparable Maine return when the entity does business in the state or has a resident partner or shareholder in the state. 25 Missouri requires that every partnership having a resident partner or having income derived from sources in the state file a return for the tax year. 26
In addition to the obligation to file a return on behalf of the passthrough entity, many states require passthrough entities to withhold and remit income taxes on behalf of nonresident owners. The withholding requirements generally apply equally for S corporations, partnerships, LLCs, and other types of passthrough entities. For instance, Colorado requires partnerships to pay tax on behalf of nonresident partners at the highest marginal individual income tax rate. Withholding is not required if the partnership files an agreement signed by the nonresident partner. 27 Form DR-0107, Colorado Nonresident Partner or Shareholder Agreement, states that the partner will file an income tax return, make timely payments of taxes, and be subject to personal jurisdiction in Colorado for purposes of collecting unpaid taxes together with related penalties unless the partner participates in the filing of a composite return filed by the partnership. Kansas requires partnerships, S corporations, and LLCs with nonresident owners to withhold Kansas income tax on the nonresident owners’ distributive share of Kansas-source income at the maximum tax rate imposed on individuals. 28 Withholding applies regardless of whether the income is distributed to nonresident owners. Statutory provisions that require withholding define “nonresident owner” as an individual, corporation, or another passthrough entity.
In contrast, Mississippi does not impose an entity-level income tax withholding obligation on partnerships. Rather, the partners are generally required to include partnership income in their income tax returns. In the event the partners of the partnership fail to timely report and pay tax owed, the partnership and its general partner(s) are jointly and severally liable for the partners’ tax. To avoid such potential liability, a partnership may elect to withhold tax and remit it to the state tax commission. Partnerships electing to report tax in this manner must request permission on Form 86-387, Withholding on Partnership Income, and file that form with the state tax commission by the due date of the partnership return.
In addition to the obligation to withhold taxes on behalf of nonresident owners, states may require or permit passthrough entities to file composite returns on behalf of such owners. By way of example, Iowa statute provides that a composite return may be allowed or required. 29 The statute authorizes the director of the Department of Revenue to require a composite return if nonresident partners do not file individual income tax returns and pay taxes. Entities eligible to be included in a composite return include nonresident individuals, trusts, and estates. There is no requirement to obtain permission prior to filing a composite return; however, the passthrough entity must notify the department in writing of its intent to file a composite return before doing so. Composite filing applies only to nonresidents of Iowa who have income equal to or in excess of the statutory minimum filing amount. Despite its flexibility with respect to composite filing, Iowa does not allow individuals with other sources of Iowa income to be included in the composite filing.
Minnesota allows a partnership to file a composite income tax return of the tax on behalf of its nonresident partners. 30 There is no prefiling permission requirement to file on a composite basis; the mere filing of a composite return by the entity is considered a request to file a composite return. Nonresident partners must elect to be included in a composite filing, or the entity must withhold tax on the distributive share of the nonresident partner income. Interestingly, Minnesota allows an individual to be included in a composite return if he or she has income from other state sources provided the income is from other partnerships electing to file on a composite basis as well. This is generally not the case with composite tax filings.
Caution: In the event of a net operating loss, the preparer should consider whether it makes sense to continue filing on a composite basis due to the fact that a loss generally cannot be carried forward on the composite return.
Business Registration, Cessation Obligations
Other important considerations are the types of registrations required when doing business in a state. Many states require a certificate of authority or comparable registration authorization to conduct business in their state and impose penalties for the failure to timely comply with such requirements. These registrations may be in addition to local business licensing requirements. Even where penalties are not imposed, business owners may suffer other unintended consequences from the failure to comply with registration requirements. For example, Texas imposes a monthly penalty of not less than $100 and not more than $5,000 for each month that an entity transacts business in the state without the proper registrations. 31 California requires foreign LLPs to register with the state within 30 days of commencing business in the state, and failure to register may result in a $20 per day penalty for each day an LLP operates without proper registration. The maximum penalty is $10,000. 32 More problematic to some business owners is the inability to maintain a suit in a state court where a business fails to comply with the certification requirements.
Just as important are the requirements to withdraw or cancel business registrations and to obtain tax clearance certificates when an entity ceases operations in a state. Failure to timely comply with these requirements can lead to unnecessary expenses or exposures. For example, the $800 California minimum tax on LLCs not classified as corporations is due in the year an LLC files its articles of organization and every year thereafter until such time that the entity files a certificate of cancellation of registration with the state. Timely withdrawal reduces unnecessary costs.
Income Tax Credits
One area of concern for taxpayers is whether the owners of a passthrough entity will be allowed to claim a resident income tax credit for their distributive share of state income taxes imposed on passthrough entity income. In general, states allow a resident individual to claim an income tax credit against resident state income tax liability for taxes imposed on earned or business income subject to tax in more than one state. However, states may limit the ability to claim a credit where the taxes are imposed on the passthrough entity rather than on the owner directly. For example, Virginia allows a resident individual to claim a credit for an owner’s distributive share of state income taxes paid by an electing S corporation to a state that does not recognize the federal S corporation election; however, no credit is allowed for income taxes imposed on other types of passthrough entities, including partnerships, trusts, or estates. 33 New Jersey allows a resident individual to claim a tax credit for its distributive share of New York City unincorporated business taxes and Philadelphia business privilege taxes imposed on business income. 34
In considering whether a credit applies, states may look to the entity liable for the tax or to the type of tax involved. 35 Massachusetts provides specific criteria that must be met before a resident can claim a credit for the distributive share of taxes imposed on an S corporation:
- The S corporation paid or is obligated to pay the tax during the owner’s year;
- The tax is imposed by another state, the District of Columbia, or other specified jurisdictions;
- The tax is measured by income subject to multiple taxation; and
- The S corporation does not deduct the tax in computing distributable income. 36
The rules also state that a credit is not allowed for taxes paid to another jurisdiction if those taxes are in the nature of excise, property, or franchise taxes and are not imposed on net income.
In addition to the issues discussed above, business owners and their advisers must consider a range of other tax issues, including sales and use, gross receipts, personal property, and other types of taxes that may be imposed on entities doing business in the state.
Tax practitioners and business owners should be aware that each state sets its own requirements for the taxation of passthrough entities conducting business in its jurisdiction. Particularly at a time when states are struggling with budget deficits and looking for ways to increase revenues, states consider it a priority to ensure that taxpayers are complying with their rules and regulations. As a result, businesses looking to expand outside their home state should first carefully consider all the potential tax filing obligations to which they may be subject.
2 Willson and Windfeld-Hansen, State Taxation of Pass-Through Entities: General Principles (Tax Management Inc. 1998).
3 AR Code Ann. §26-51-409(b)(1).
4 GA Code Ann. §48-7-21(b)(7)(B).
5 NJ Rev. Stat. §54:10A-5.22; NJ Admin. Code §18:7-11.16.
6 NY Tax Law §660.
7 72 PA Code Ann. §7307.
8 TN Code Ann. §67-42006(a)(2).
9 For more information, see California Form 568, Limited Liability Company Return of Income, and related instructions.
10 NJ Rev. Stat. §54:10A-15.6.
11 35 IL Comp. Stat. 5/201. Investment partnerships are not subject to the replacement tax.
12 DC Code §§47-1810.01 and 47-1805.02(6).
13 NH Rev. Stat. Ann. §77-A:6.
14 CA Rev. & Tax. Code §23802(b)(1). A 1.5% rate applies to general corporations and a 3.5% rate to financial corporations.
15 KY Rev. Stat. Ann. §141.0401, effective for tax years beginning on or after January 1, 2007.
16 MA Gen. L. Ch. 63 §32D.
18 NY Tax Law §210(1)(d)(4).
19 CA Rev. & Tax. Code §17941.
20 CA Rev. & Tax. Code §17942.
21 CT Gen. Stat. §12-284b(b). Entity-level tax is imposed in addition to a requirement that the entity pay the applicable Connecticut corporation business or personal income tax on behalf of its nonresident members.
22 See, e.g., Appeal of Amman & Schmid Finanz AG, No. 96-SBE-008 (Cal. St. Bd. of Equal. 4/11/96); FL Admin. Code Ann. §12C-1.011(1)(v).
23 CT Gen. Stat. §12-214(a); 103 KY Admin. Regs. §16:240(4).
24 NJ Admin. Code §18:7-7.6.
25 See instructions for Maine Form 1065ME/1120S-ME, Maine Information Return Partnerships/LLCs/S Corporations.
26 MO Rev. Stat. §143.581.
27 CO Rev. Stat. §39-22-601(5)(e).
28 KS Stat. Ann. §§79-32,100(b)–(d).
29 IA Code §422.13(5).
30 MN Stat. §289A.08, subd. 7(a)–(h).
31 TX Rev. Civ. Stat. Ann. Art. 1528n, §7.13.
32 CA Corp. Code §16959.
33 23 VA Admin. Code §10-110-221.C.
34 “New York City UBT/Philadelphia BPT,” New Jersey State Tax News 4 (Spring 2000).
35 See RI Div. Tax’n, Admin. Hearing Decision No. 2002-01 (2/13/00). The taxpayer was not allowed a resident income credit for New Hampshire business taxes for personal taxes paid on gains from the sale of residential real estate. The business profits tax, while in the nature of an income tax, is not an income tax but rather a tax on business profits. In addition, the tax was not imposed on the individual but on the rental real estate sole proprietorship.
36 See MA Gen. L. Ch. 62 §6(a); 830 MA Code Regs. §62.17A.1(5)(e); and MA Dept. of Rev. Directive 08-6 (12/18/08).
Harlan Kwiatek is with Rubin Brown LLP in St. Louis, MO, and is chair of the AICPA Tax Division’s State & Local Tax Technical Resource Panel. Karen Nakamura is director of tax knowledge management with PricewaterhouseCoopers LLP in Washington, DC, and is immediate past chair of the State & Local Tax Technical Resource Panel. Margarete Chalker is with Plante & Moran PLLC in East Lansing, MI, and is a member of the State & Local Tax Technical Resource Panel. For more information about this column, contact Ms. Nakamura at email@example.com or Ms. Chalker at firstname.lastname@example.org.