What happens when an entity derives income from doing business in multiple states? If the company is a C Corporation and already pays tax at the entity level, the company pays all of the state taxes. However, for pass-through entities, the answer depends on the state.
Pass-through entities are partnerships and S Corporations.* Limited Liability Companies (LLCs) which are reported as partnerships or S Corporations are also pass-through entities. In most cases, these entities do not pay federal income taxes, but rather pass through the income to the entity’s owners. The owners receive a Schedule K-1 tax document that provides information on how to report income and deductions on their federal and state income tax returns. While it’s possible for income to pass through multiple entities before getting to a tax-paying owner such as an individual or C Corporation, individual owners are the focus of this article.
Multi- business owners’ options vary from state to state
Some jurisdictions, such as Texas and Washington, D.C., assess tax based on income to the entity itself. The entity is treated similarly to being a C Corporation as the income is not passed through to the owners of the company for taxation. Most other states require the entity to pass through the income to the owners. In this case, the owners have to file and pay income taxes in each state in which the entity does business. Some owners have been remiss in reporting and paying taxes to the various states and the states are focusing on making the entity responsible for remitting taxes on its owners’ behalf.
The most common requirement imposed by the states is for the entity to withhold income taxes at a percentage of the state’s apportioned taxable income and remit the withholding to the state. The owner can then claim the withheld taxes as a payment on the state return the owner files; much like withholding on wages is claimed when filing the income tax return for the year. While the withholding requirement likely applies to nonresident owners who are individuals, states vary on whether withholding is required on nonresident owners which are entities.
Many states allow the entity the option of filing one composite or group return on behalf of non-resident owners. The entity pays the tax and the owners are not required to file individual tax returns in that state; however, the tax payment is attributed to the individual owner as the owner is ultimately responsible for the tax.
Some states, such as North Carolina and Colorado allow an affidavit or agreement to be signed by the owner acknowledging responsibility for filing and paying the state income tax, relieving the entity of the responsibility.
States requiring withholding, a composite or a nonresident owners’ affidavit
The following points must be considered if your pass-through entity is doing business in a state requiring withholding, composite returns or filing a nonresident owners’ affidavit:
- Affidavits are the easiest at the company level, but require the most work at the owner level. The owner will be required to file a state tax return and possibly estimated tax payments throughout the year.
- Depending on the state, withholding is often the next easiest at the company level, but owners are still expected to file returns with the state.
- The amount of withholding required for the year is generally determined on the annual state return filed by the entity.
- Only some states, such as Maryland and Ohio, require quarterly estimated taxes to be paid at the entity level. Other states, such as Virginia and North Carolina, do not require quarterly payments for withholding taxes.
- The owner files a state return and claims the amount of withholding. Often the withholding paid by the company will equal or exceed the owner’s tax liability for the state, so no additional payments are due. If withholding exceeds the tax liability, the overpayment may be refunded to the owner. It should be noted that the withholding requirements for the entity may not provide for deductions such as Section 179 or other modifications resulting in excess taxes being withheld. The overpayment will be refunded when the individual return is filed.
- While often causing an additional return to be filed at the company level, composite returns relieve the individual owners from filing in the state. This option is very attractive if there are a number of non-resident owners or the entity files in a number of states and the company wishes to relieve the owner of the responsibility of filing multiple state returns.
- Composite taxes are often computed at the highest rate of tax for the state. Deductions allowed on an individual return may not be allowed on a composite return. Composite returns can result in more taxes being paid to the state.
- Taxes paid to states other than the owner’s state of residence, either via an individual return or via a composite return, should result in a credit on the resident state return. The amount of the credit will be the lesser of the resident state tax or tax paid to the other state on the double-taxed income.
- Owners allowed to participate in a composite return may be limited to individual, non-resident owners with no other income from the particular state.
- Composite returns may, or may not, allow for loss carryovers. Losses reported on a prior year individual return may not be applied on a current year composite return and vice versa.
- Both state withholding tax payments and composite tax payments should be considered distributions to the owners. Even though the company is required to remit the tax, it is the owners’ tax liability.
Just a few of the many items to consider when doing business in multiple states are included above. Don’t miss out on learning the most efficient and economical way to file and pay state income taxes. Contact your tax advisor or PBMares’ State and Local Tax Team to discuss your specific multi-state-business needs.
*Note – a fiduciary (trust or estate) may also be considered a pass-through entity, but is outside the scope of this discussion.