Multi-state S Corp.: Shareholder Abode

Written by Gregory Fallon, EA, MST on Thursday, 29 August 2013.

Multi-state S Corp.: Shareholder Abode

When I start work on a multi-state S Corp. return I first consider where all the shareholders have abode. This is important because if their state imposes income taxes they will be taxed on their worldwide income. For example, If all the shareholders of an S Corp. live in a high tax state such as CA scheming to apportion income out of CA will provide no income tax benefit since they will be taxed on worldwide income in CA (however, it would lower the franchise taxes paid at the entity level). Many states allow credits for taxes paid to other states to prevent double taxation. In effect, use of these credits will simply allocate the total tax bill not lower it. Therefore, filing in states can eliminate income tax contingencies without increasing over all taxes. Many owners believe filing in another state will caused double taxation and fail to consider credits and income apportionment formulas.

When I start work on a multi-state S Corp. return I first consider where all the shareholders have abode. This is important because if their state imposes income taxes they will be taxed on their worldwide income. For example, If all the shareholders of an S Corp. live in a high tax state such as CA scheming to apportion income out of CA will provide no income tax benefit since they will be taxed on worldwide income in CA (however, it would lower the franchise taxes paid at the entity level). Many states allow credits for taxes paid to other states to prevent double taxation. In effect, use of these credits will simply allocate the total tax bill not lower it. Therefore, filing in states can eliminate income tax contingencies without increasing over all taxes. Many owners believe filing in another state will caused double taxation and fail to consider credits and income apportionment formulas.

Once I map out where all the shareholders have adobe I determine state by state if it makes sense for the S Corp. to file a composite return. If all the shareholders have adobe in a state with the highest tax rate filing composite returns might make sense even if filing a nonresident returns produces a lower tax bill. Regardless of what is paid to the nonresident state worldwide income will be fully taxed in the shareholder’s state of adobe. Example: Jimbo Jones is taxable on worldwide income in state A but also has tax liabilities of $4 in state B on income of $100. State A taxed the same $100 at its rate of 10%. Jimbo Jones will owe $10 to state A on this same $100 but if state A provides a credit for taxes paid to states B Jimbo Jones will have a $4 credit and pay a net tax of $6 to state A. Filing a composite return will lower the number of returns that need to be filed and allow the S Corp to pay and track estimated taxes at the entity level vs. every shareholder having to send in their own estimated payments plus file annual nonresident returns. State income tax estimates paid by the S Corp are distributions to the shareholders but should be accounted for separately for tracking purposes. Composite filings make administration easier and also ensure that state tax liabilities are met but there availability can be limited. In most states composite return will require all shareholders to sign a form certifying they agree to the filing, are nonresidents, and that their only income producing activity in the state is from the S Corp. So in most cases a composite return will only be allowed when all the shareholders are non-residents and have no other income producing activity in the state. Another factor to consider before filing a composite return is how credits for taxes paid to other states are applied between the various states. In most cases shareholders can take a credit for taxes paid by the S Corp. on their behalf against their state income taxes but there are a few odd ball states like CA, AZ, and VA. They only allow credits for taxes paid to other states if the taxpayer is not allowed to take a credit in the nonresident state for taxes paid to them. States like CA, AZ, and VA allow taxpayers to pay the tax in their adobe state and then take a credit in their state. I call these reverse credit states. If the S Corp files a composite return in VA and has a shareholder with adobe in AZ the shareholder will pay AZ tax on their worldwide income and receive no credit for the state income taxes paid to VA on its behalf. AZ will not allow the credit for income taxes paid to VA since the taxpayer had the option to take a credit in VA for taxes paid in AZ. Understanding the application of state credits for income taxes paid to other states is paramount when deciding how to file an S Corp.

With the explosion of pass-through entities in the last 10 years many cash strapped states are passing statues enabling them to collect taxes at the entity level. NM now requires certain pass-through entities to remit a withholding tax on owner’s share of income on a quarterly basis. A number of states such as UT, NE, and OK require S corps to file and pay withholding taxes but these returns are not composites and shareholders are still required to file as individuals. Although, many taxpayers may groan at the idea of having to file in more states it should be communicated that filing may not increase their over all taxes and that state penalties for not filing can be most unpleasant. In many cases filing in more states will not drastically increase a taxpayer’s taxes but it will prevent expensive state income tax contingencies.

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Gregory Fallon, EA, MST

Gregory Fallon, EA, MST

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