States provide income tax credits to businesses, generally, for expansions or relocations. While state income tax credits are usually well-designed to reduce the state income tax liability of C corporations, they do not work as well for partnerships or S corporations if the business owners are not residents of the state in which the business is located. Because of the state method of taxing individual owners of passthrough entities (full taxation in their state of residence, with an offsetting credit for taxes paid to states where the owner is not a resident), the benefit of a state income tax credit, if it is earned in a state where the owner is not resident, is often lost, providing an unwelcome surprise for business owners.
This counterintuitive tax result occurs because C corporations and individuals are subject to fundamentally different regimes for state income tax reporting. C corporations are almost always required to apportion and allocate their federal taxable income (with numerous and growing modifications) to the various states based on a ratio of sales sourced to each state over total sales. (There are many variations to this approach.) Individuals are generally required to report all of their worldwide income to their state of residence and are also required to report and pay tax on any income earned in other states. Nearly every state that has a personal income tax permits its residents to calculate a credit against the resident state tax. Typically, the credit for taxes paid to other states is equal to the resident state's tax rate applied against the income that was subject to taxation outside the state. It should be noted that there is significant diversity among the states in the approach to these calculations.
A passthrough entity is generally required to allocate and apportion the federal taxable income base (with various state-specific modifications) among the states in a manner that is substantially the same as for C corporations. Passthrough entities are also often required to withhold and remit tax on the income apportioned to the state that is distributable to the owners who are nonresidents. From the states' perspective, it is up to the nonresident individual to file a nonresident income tax return to calculate the correct tax.
From the individual owner's perspective, all of the income will be subject to tax in his or her state of residence. The importance of the credit for taxes paid depends on the approach particular states have taken in taxing, or not taxing, individual income. In the case of states that do not have an individual income tax, it is of no importance at all (e.g., Florida, Texas, and Washington). In states that have a relatively high tax rate (e.g., California, New Jersey, New York, and Minnesota), it is likely that in most cases any calculation of the credit for taxes paid on the resident state return will include the majority of multistate taxes paid by the individual owner to nonresident states. In those states that have a relatively modest individual income tax rate (e.g., Illinois, Ohio, and Pennsylvania), the calculation for the credit for taxes paid on the resident state return will not cover the entire amount of multistate tax paid by or on behalf of the individual owner. (It should be noted that Illinois has a remarkably generous approach for calculating the multistate credit for taxes paid and that, in the authors' experience, it is the rare Illinois taxpayer who has a multistate tax liability that is not completely credited on his or her Illinois resident income tax return.)
Example. A wasted (or shifted) state income tax credit: A business that is organized as a passthrough entity operates solely in State A. The business is owned 33.33% each by an individual resident of State A, a resident of State B, and a resident of Florida. Assume State A and State B each impose a 5% income tax on individuals, including on income from passthrough entities.
The business worked with representatives of the economic development organizations of State A and was awarded a $600,000 income tax credit from State A as an incentive for developing a new facility. In the first year the new facility was operational, the passthrough entity had State A taxable income of $12 million and a tax liability of $600,000 that was entirely offset by the credit.
For the State A and the Florida resident owners, the result is zero state income tax liability from the passthrough entity for the year. The State A resident owner includes $4 million of income on his State A resident return, computes a tax liability of $200,000, and claims a $200,000 credit. The Florida resident owner files a nonresident return in State A reflecting $200,000 of tax liability from the passthrough entity and a $200,000 credit.
Unfortunately, the owner who resides in State B receives an unwelcome surprise when filing his State B individual income tax return. The first step for this owner is to file a nonresident return in State A. Just like the Florida owner, he files a nonresident return in State A reflecting $4 million of income from the passthrough entity, a $200,000 tax liability, and a $200,000 credit. The result is that no taxes are due to StateA.
The next step is to prepare his resident individual income tax return in State B. Assuming the passthrough entity is the individual's only income, his State B resident taxable income is $4 million with a corresponding tax liability of $200,000, before a credit for taxes paid to State A. Because owner B paid no individual income tax to State A because of the credit, he will not receive a credit for taxes paid to other states, and he will owe $200,000 on his State B individual return. As a result, the owner who resides in State B ultimately receives no benefit for the passthrough entity's economic development incentive.
The takeaway from this example is that, if all individual owners reside in the same state as the location of the passthrough entity or in states with no individual income tax, the economic development credit ultimately delivers tax savings to the owners. However, if all or a majority of the owners are nonresidents who live in states that impose an income tax, the net effect of the State A economic development tax credit from the owners' perspective would likely have been zero tax savings.
In the authors' experience, of the states that are more aggressive in offering income tax credits, a handful have adapted their programs in ways that work well for passthrough entities. In those states that have not fully adapted to the needs of passthrough entities, passthrough business entities may be able to negotiate incentive deals that are not based on income tax credits. For example, some states have made changes to allow taxpayers to choose to apply the tax credit to their employees' wage withholding. Another trend is to make income tax credits refundable or transferrable. Some states have moved entirely away from income tax credits and use sales tax incentives, property tax abatements, grants, infrastructure support, low-interest loans, and utility abatements.
Before negotiating state incentives, passthrough entities should carefully consider the tax implications not only in the states in which they have business operations, but also in the states where their individual owners reside. Further, entities should also consider whether an incentive that is not based on income tax credits would be more beneficial in reducing the entity's overall multistate tax liabilities. A review of these considerations can help passthrough entities avoid receiving a tax credit that does not provide the intended benefit.
Howard Wagner is a partner with Crowe LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe LLP.