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State Taxation of S Corporations (Portfolio 1510)

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DESCRIPTION

Since the S corporation's hybrid nature often conflicts with the various state tax schemes it encounters in multistate business operations, the State Taxation of S Corporations Portfolio begins with a discussion of the issues that arise during the corporation's formation and the making of its S election.

 

With respect to the taxation of the corporation and its shareholders, this Portfolio provides a thorough analysis of the myriad state treatments of distributions, stock sales, redemptions, liquidations, reorganizations, and S election terminations.

 

This Portfolio also contains detailed explanations of the adjusted basis rules encountered by S corporation shareholders. Particular attention is paid to the states' lack of conformity with the federal income tax system.

 


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AUTHORS

JAMES EDWARD MAULE, ESQ.

James Edward Maule, Esq., is a Professor of Law at Villanova University School of Law. James is a lecturer at the Villanova University Graduate Tax program and Tax Forum CLE Programs, Philadelphia Bar Association Tax Section and has formerly lectured at ALI–ABA, Tax Management Inc.  and Continuing Legal Education Satellite Network, Pennsylvania Bar Institute, and the Dickinson School of Law CLE Programs. He is a member of the American Bar Association, Section on Taxation, Committee on S Corporations (consultant and former Chair, Subcommittee on Subchapter S and State Law; former Chair, Subcommittee on Comparison of Partnerships and S Corporations; former Member, Task Force on Legislative Recommendation No. 86–1) and the American Bar Association, Section on Taxation, Committee Teaching Taxation (Chair, Subcommittee on Manuscripts and Unpublished Teaching Materials). He is also a former member of the American Bar Association, Tax Section Task Force on Pass–Through Entities and the Philadelphia Bar Association Tax Section. James is the owner of Tax JEM Inc., publisher of computer assisted legal instruction programs, author of numerous books, monographs, and book chapters and contributor to various tax periodicals.

 

Credentials / B.S., University of Pennsylvania, J.D., Villanova University, L.L.M. (Taxation), George Washington University.

 


TABLE OF CONTENTS

Detailed Analysis

1510.01. INTRODUCTION

A. Impact of State Taxes and State Law: Overview

1. In General

2. State Income Taxation

3. Other State Taxes

4. Other State Laws

B. Source of State Income Tax and Other Laws

C. Conformity with Federal Internal Revenue Code

1. In General

2. Particular Approaches

3. Constitutional Problems

D. Terminology Used in Discussing State Income Tax and Other Laws Affecting S Corporations and Their Shareholders

E. State Legislative Reform of Federal–State S Corporation Analysis

1. Background

2. The Model S Corporation State Income Tax Act

1510.02. ACHIEVING S CORPORATION STATUS

A. Introduction

B. States That Ignore the Federal S Election

C. States That Permit Optional State S Elections

D. States That Automatically Adopt The Federal S Election

1. In General

2. Impact of State Recognition of the Federal S Election

E. Qualification Requirements for State S Election

1. In General

2. Scope of Compliance Requirements

3. Failure to Comply

4. Conformity Problems

F. Qualified Subchapter S Subsidiaries

1. In General

2. Chain QSSSs

3. QSSS Election

4. State Conformity

a. Alabama

b. California

c. Florida

d. Hawaii

e. Louisiana

f. Massachusetts

g. Michigan

h. Minnesota

i. New York

j. Pennsylvania

k. Rhode Island

l. South Carolina

m. Texas

n. Utah

o. Virginia

G. Impact of Nonresident Shareholders

1. In General

2. Effect of Noncompliance

1510.03. FORMATION OF, OR CONVERSION TO, AN S CORPORATION

A. Introduction

B. Formation of An S Corporation: Nonrecognition Treatment

C. Selecting the S Corporation's Taxable Year

1. In General

2. Explicit Adoption of Federal Taxable Year

3. Implicit Adoption of Federal Taxable Year

4. Specific Definition

5. No Definition

D. Adoption of an Accounting Method

1. In General

2. Explicit Adoption of Federal Accounting Method

3. Implicit Adoption of Federal Accounting Method

4. Specific Definition

5. No Definition

1510.04. STATE INCOME TAXATION OF S CORPORATIONS

A. Introduction

B. Scope of State Income Taxation of S Corporations

1. Introduction

2. Taxation Patterns

a. State With No Corporate Income Tax

b. States That Do Not Tax S Corporations

c. States That Follow Federal Pattern

d. Taxation of Passive Income and Capital Gains

e. Taxation of Capital Gains Only

f. Taxation of Built–In Gains Only

g. Taxation of Nonresident Shareholders

h. Withholding Obligations With Respect to Nonresident Shareholders

i. States That Tax S Corporations as C Corporations

3. Minimum Income Taxes

4. Recapture Taxes

a. Recaptured Credits

b. LIFO Recapture Tax

5. Other Taxes

a. Estimated Taxes

b. Miscellaneous Taxes

6. Exemption for Incidental Sales

C. Corporate Income Subject to Income Taxation

1. Introduction

2. Computation of Corporate Taxable Income

a. In General

b. Modifications

c. Deduction For Federal Income Taxes

3. Taxable Income of S Corporations: Specific Rules

a. In General

b. Impact on Modifications

c. Limited State Income Taxation

4. Income Within State Taxing Jurisdiction

a. In General

b. Bases for Jurisdiction

c. Federal Limitations

d. Allocation and Apportionment

(1) In General

(2) Application

(3) Specific Allocation

(4) Apportionment

(5) Unitary Method for S Corporations

(6) Impact on S Corporations

5. Treatment of Losses

6. Credits for Income Taxes Paid

a. Taxes Paid By Corporation to Other States

b. Taxes Paid by Shareholders to Other States

c. Taxes Paid by Corporation

D. Filing Requirements

1510.05. TAXATION OF S CORPORATION SHAREHOLDERS

A. Scope of State Income Taxation of S Corporation Shareholders

1. Introduction

2. Taxation Patterns

a. States That Have No Individual Income Tax

b. No Shareholder Taxation Because S Election Not Recognized

c. Shareholder Not Taxed On Part of S Corporation Income

d. Shareholders Taxed on All S Corporation Income

(1) Shareholders Only Are Taxed

(2) Corporation Taxed on Some S Corporation Income

(3) Shareholders and Corporation Taxed on Corporation's Entire Income

e. Nonresident Shareholders Not Taxed

3. Exemption for Incidental Sales

B. Computation of Income Taxed to Shareholders

1. Introduction

2. Methods of Taxing S Corporation Income to Shareholders

a. In General

b. Shareholders' S Corporation Income Based on Federal Income

(1) In General

(2) Separately Stated Items

(3) State Modifications for Individual Income Tax

(i) In General

(ii) Justification for Modifications

(4) State Modifications for Corporation Income Tax

(i) In General

(ii) Modification Phaseouts

(5) Effect of Provisions Contrary to Pro Rata Rule

(6) Effect of Provision Requiring Specific Inclusion of S Corporation Income

c. Shareholder S Income Based on State Computation

(1) In General

(2) Separately Stated Items

(3) Determination of S Corporation Income

(4) Determining Shareholders' Distributive Shares

(i) Application of Federal Pro Rata Rule

(ii) Modifications

d. Adjustments for Items Taxed to S Corporation

(1) In General

(2) Adjustment for Items That are Taxed

(3) Adjustments for Income Taxes

(i) Federal Income Taxes

(ii) State Income Taxes

(4) Credits for Taxes Paid by S Corporation

e. Treatment of Distributive Shares – Losses

(1) In General

(2) Limitations on Deductibility

(3) Carryover of Disallowed Losses

(4) Using Disallowed Losses in the Post–Termination Transition Period

(5) Losses Carried To and From C Corporation Years

(i) Shareholder Limitations

(ii) Corporate Limitations

(iii) Time Limitations on Loss Carryforwards

3. Tax Elections

4. Treatment of State Credits Allowed for Policy Reasons

a. In General

b. Credits That Pass Through To Shareholders

c. Credits That Do Not Pass Through

5. S Corporations That Do Business for Only Part of Year

6. Shareholder Treatment When State S Election Not Made

a. In General

b. Nontaxation of Shareholders

c. Shareholders Taxed

C. Taxation of Resident Shareholders of S Corporation with Multistate Business Activities

1. In General

2. Jurisdiction to Tax Resident Shareholders On Income From Other States

3. Scope of Taxation of Resident S Corporation Shareholders

a. In General

b. S Corporation Income Taxed by State of Residence

4. Credits for Taxes Paid by S Corporation to Other States

a. In General

b. Credit Denied

c. Credit Allowed

(1) In General

(2) Adjustments to Taxable Income

d. State Taxation of S Corporation With Respect to Nonresident Shareholders

5. Credits for Taxes Paid by Resident Shareholders to Other States

a. In General

b. Source of Income Generating Credit

c. Specific Types of Income

d. Reciprocity

e. Computation Limitations

f. Application of Credits to S Corporations and Their Shareholders

(1) In General

(2) Credit Limited to Specific Types of Income

(3) Resident Shareholder Not Taxed by State of Residence

(4) Source Limitations

(5) Different Tax Rates Applicable To Different Types of Income

g. Income Allocated or Apportioned to Other State

(1) In General

(2) Application of Allocation and Apportionment to S Corporation Income

(3) Treatment of Shareholder as Engaged in Corporation's Activities

(4) Level of Application

(5) S Corporation Doing Business in State for Less Than Entire Taxable Year

D. Taxation of Nonresident Shareholders

1. In General

2. Shareholders Within State's Jurisdiction To Tax

a. Introduction

b. Limitations on State Jurisdiction To Tax Nonresidents

3. Definition of Nonresident Shareholder

a. In General

b. Definition of Nonresident

c. Residency Definitions

4. Methods of Taxing Nonresident Shareholder's Income

a. In General

b. Application of Source Rules

c. Enforcement

d. Treatment of Losses

e. Effect of Reciprocity Provisions

f. Application of Modifications to Nonresident Shareholders

5. Credits for Taxes Paid by Nonresident to Other State

a. In General

b. Income Generating Credit

c. Credit Reciprocity

d. Limitation

e. Application to S Corporations and Their Nonresident Shareholders

(1) In General

(2) Nonresidents Not Taxed by State of Residence

(3) Nonresidents Taxed by State of Residence

(4) Source Limitations

6. Credits for Taxes Paid by S Corporation to Other States

7. Nonresident Shareholders – S Corporation Income Source Rules

a. In General

b. Specific Nonresident Source Rules

(1) Nonresident Shareholder Distributive Share Sourced Entirely Within State

(2) Nonresident Shareholder Distributive Share Sourced Through Allocation and Apportionment

(3) Nonresident Shareholders Distributive Share Sourced Entirely Without State

(4) Source Rules Applicable to Nonresident Shareholder Losses

c. Application of General Source Rules

d. Allocation and Apportionment

(1) In General

(2) Applicable Allocation and Apportionment Rules

(3) Application of Allocation and Apportionment Rules to Nonresident Shareholders

E. Part–Year Residency

1. In General

2. Taxation of S Corporation Shareholder Who Changes Residency During Taxable Year

F. Shareholder Compliance Problems

1. Shareholder Return Filing Requirements

2. Composite Returns

3. Enforcement of Shareholder Taxation

a. In General

b. Constitutional Concerns

c. Information Reporting

d. Loss of S Treatment

e. Withholding

(1) Mandatory Withholding

(2) Elective Withholding

(3) Conditional Withholding

f. Taxation of S Corporation

g. Payment on Behalf of Shareholders

G. Related Issues

1. Determining Shareholder Gross Income

2. Shareholder Compensation

a. In General

b. Assignment of Income

c. Different Treatment of Earned Income

d. State Personal Service and Compensation Rules

3. Alternative Minimum Tax

4. Miscellaneous Matters

5. Transitional Problems With Newly Enacted Income Tax

1510.06. SHAREHOLDER ADJUSTED BASIS

A. Introduction

B. Computation of Shareholder Adjusted Basis for State Income Tax Purposes

1. In General

2. States That Recognize The S Election

a. In General

b. Adjusted Basis Rules

(1) Specific State S Corporation Adjusted Basis Rules

(2) Specific State Adjusted Basis Rules

(3) Modified Federal Adjusted Basis

(4) Federal Adjusted Basis Modified for Date of S Election Adoption

(5) Federal Adjusted Basis Modified for Date Income Tax Enacted

(6) Explicitly Unmodified Federal Adjusted Basis

(7) Implicitly Unmodified Federal Adjusted Basis

c. Problems With Adjusted Basis Rules

(1) In General

(2) Lack of Specific S Corporation Adjusted Basis Rules

(3) Limited Scope of Adjusted Basis Rules

(4) Inconsistency in Parallel Rules

(5) Use of Federal Adjusted Basis

(6) Effect on Nonresident Shareholders

(7) S Corporation Doing Business in More Than One State

3. States That Do Not Recognize The S Election or Election Not in Effect

a. In General

b. Adjusted Basis Rules

(1) Specific State Adjusted Basis Rules

(2) No Adjusted Basis Rules

(3) Adjustments if S Election Not in Effect

c. Problems With Adjusted Basis Rules

C. Impact of State Audit Adjustments

1510.07. TAXATION OF S CORPORATION DISTRIBUTIONS

A. Introduction

B. Distributions in States That Do Not Recognize S Elections

1. In General

2. State Earnings and Profits

3. State S Election Not Made

C. Distributions in States That Recognize the S Election

1. In General

2. Definition of Dividend

3. Accumulated Adjustments Account

4. Distribution of Income From Taxable Years Preceding the Effective Date of the State S Election

a. In General

b. Lack of Separate State Accumulated Adjustments Account

5. Distributions of Income From Taxable Years Before State Income Tax Enacted

6. Distributions of Property

a. Gain Property

b. Loss Property

D. Taxation of Distributions to Resident Shareholders by Corporations That Do Business in More Than One State

1. Introduction

2. Taxation of Distributions From Corporations That Do Business in More Than One State

3. Application of Allocation and Apportionment Rules

a. In General

b. Previously Taxed Income

c. Gains

4. Credits for Taxes Paid by Resident Shareholders to Other States

a. In General

b. Credit Provisions Applied to Dividend Distributions

c. Credit Provisions Limited to Specific Types of Income

d. Nonrecognition of the S Election

e. Timing Problems

E. Taxation of Distributions to Nonresident Shareholders

1. Introduction

a. In General

b. S Election Not Recognized

c. S Election Recognized

(1) In General

(2) Specific Nonresident S Corporation Shareholder Distribution Rules

(3) General Nonresident Dividend Rules

(4) Taxation of Gain

2. Credits for Taxes Paid by Nonresident Shareholders to Their States of Residence

3. Corporation Doing Business in More Than One State

a. In General

b. Taxation of Distributions From Corporation Doing Business in More Than One State

1510.08. TAX CONSEQUENCES OF S CORPORATION STOCK SALES

A. Introduction

B. Determination of Shareholder Gain or Loss

1. In General

2. S Corporation That Does Business in More Than One State

a. In General

b. Jurisdiction to Tax Resident Shareholders' Stock Sales

c. Scope of Taxation of Resident S Corporation Shareholders' Gain or Loss

d. Credits for Taxes Paid by Resident Shareholders to Other States on Stock Disposition Gains and Losses

e. S Corporation Stock Dispositions Sourced Within the State of Residence

(1) In General

(2) Specific Allocation of Gain and Loss

(3) Apportionable Gain and Loss

(4) Application to Resident Shareholder Stock Disposition Gain and Loss

(5) Treatment of Shareholder as Engaged in Corporation's Activities

3. Treatment of Nonresident Shareholders

a. In General

b. Gain or Loss Within A State's Taxing Jurisdiction

(1) In General

(2) Limitations on State Jurisdiction To Tax Nonresident Shareholder Stock Disposition Gains and Losses

(a) In General

(b) Arguments Concerning Jurisdiction

(3) Methods of Taxing Nonresident S Corporation Shareholders' Stock Disposition Gains and Losses

C. Apportionment of S Corporation Items Between Selling and Purchasing Shareholders

1. Introduction

2. Proration and Interim Closing Methods

3. Differences in Residency

a. In General

b. Consistent Positions Taken on Interim Closing Election

c. Inconsistent Positions Taken on Interim Closing Election

D. Corollary Effects

1. Introduction

2. Alternative Minimum Tax

3. Recapture Items

E. Worthless Stock Losses

1510.09. TAXATION OF S CORPORATION STOCK REDEMPTIONS

A. Introduction

B. Classification of Redemptions

1. State Adoption of IRC 302(b) Principles

2. State Adoption of IRC 303 Principles

3. Exceptions to Federal Principles

C. Consequences to Shareholders

1. Redemption Treated as Distribution

2. Redemption Treated as Exchange

D. Consequences to the S Corporation

1. Redemption Treated as Distribution

2. Redemption Treated as Exchange

a. In General

b. Adjustments to S Corporation's Accounts

E. Redemptions Treated Differently by Different States

1510.10. TAXATION OF S CORPORATION LIQUIDATIONS

A. Introduction

B. Consequences of Liquidating Distributions to Shareholders

1. In General

2. Recognition of Gain or Loss

a. In General

b. Problems in Applying General Disposition Gain and Loss Principles to Liquidations

c. Planning Opportunities

3. Shareholders' Adjusted Bases in Distributed Assets

4. Taxation Of S Corporation's Liquidation Gain or Loss

C. Consequences to S Corporations

1510.11. TAXATION OF S CORPORATION REORGANIZATIONS

A. Introduction

B. Qualifying for Reorganization Treatment

C. Treatment of S Corporation

1. In General

2. Specific State Reorganization Rules

D. Treatment of Shareholders

1. In General

2. Effect of Nonresident Shareholders

3. Application of Allocation and Apportionment Rules

1510.12. EFFECT OF S ELECTION TERMINATION ON STATE INCOME TAXES

A. Introduction

B. Causes of Termination

1. In General

2. States With Separate S Elections

a. Conformity With Federal Causes

b. Revocation of S Corporation Status

c. Excess Passive Income

3. States That Adopt the Federal S Election

C. Effective Date of Termination

D. Making the Election After Termination

E. Temporary Suspension of State S Election Recognition

F. Consequences of Termination

1. In General

2. Division Into Two Separate Years

a. In General

b. Separate State S Election

c. Modifications

d. Tax Return Due Dates

e. Inconsistent Interim Closing Elections

f. Termination in All States

(1) In General

(2) Consistent Interim Closing Election Rules

(3) Inconsistent Positions Taken on Interim Closing Election

g. Impact of Doing Business in State That Does Not Recognize The S Election

(1) In General

(2) Apportionment Problem

(3) Credit Problem

3. Post–Termination Transition Period

4. Termination for Purposes of One State's Income Tax

a. In General

b. Computing the Credit for Taxes Paid to Another State

c. S Election Not in Effect for Entire Year

5. Impact on Pass–Through of Credits

1510.13. TAXES OTHER THAN INCOME TAXES

A. Introduction

B. Intangibles Taxes and Personal Property Taxes

1. In General

2. Scope of Tax

3. Applicability to S Corporations

4. Constitutional Issues

C. State Unemployment Insurance Taxes

D. Gross Receipts Taxes

E. Sales Taxes

F. Net Earnings Taxes

G. Estate Taxes

H. Excise Taxes

1510.14. CORPORATE FEES AND TAXES

A. Introduction

B. Initial Fees

C. Annual Registration Fees

D. Capital Stock and Franchise Taxes

1. In General

2. Income as Measurement Factor

3. Application to S Corporations

1510.15. EFFECT OF S ELECTION ON VARIOUS STATE LAW ISSUES

A. Introduction

B. Effect of S Election on Corporate Law Issues

1. In General

2. State Laws Affecting Shareholder Rights

a. Computation of Damages and Amounts Subject to Restitution

b. Right To Compel Distribution of S Corporation Income

c. Ensuring Corporation's Qualification for S Status

d. Fiduciary Duties

e. State Regulation of Dividend Payments

f. Shareholders' Damages Against Third Parties

3. Contracts for Sale of S Corporation Stock

a. Valuation and Consideration Problems

(1) In General

(2) Book Value Valuation

(3) Contractual Allocation of Tax Liabilities

(4) Social Security Taxes

(5) Consideration Other Than Cash

b. Executory Contracts and Conditions Precedent

4. S Corporation's Rights Against Third Parties

5. Third Parties' Rights Against S Corporations

a. Piercing the S Corporation “Veil”

b. Corporate Responsibility for Shareholder Obligations

c. Power To Bind S Corporation

6. State Securities Regulation

C. Effect of S Election on the Economics of Divorce

1. In General

2. S Corporation Profits During Marriage

3. Maintaining S Corporation Status

a. In General

b. Planning Techniques

4. Drafting References to S Corporation Shareholder's Income

D. Effect of S Election on Property Rights

1. Introduction

2. State Trust Laws Applied to S Corporations

a. In General

b. Definition of Trust Income and Trust Beneficiary's Share of Trust Income

c. Effect of Community Property Laws on Qualification of Grantor Trust as S Corporation Shareholder

d. Reformation of Trusts Under State Law

3. Probate Matters

a. In General

b. Ensuring Corporation's Qualification for S Status

c. Rights of Surviving Spouse

4. Other Matters

E. Miscellaneous State Law Issues

1. Introduction

2. Problems of Corporation's Professional Advisor

3. Workers' Compensation Law

4. Public Utility Rate Setting


WORKING PAPERS

Working Papers

Item Description Sheet

Worksheet 1 State Conformity With Federal S Corporation Election

Worksheet 2 Model S Corporation Income Tax Act and Commentary (Proposed by the Subcomittee on State Taxation of S Corporations, American Bar Association, Section of Taxation)

Worksheet 3 Model S Corporation State Income Tax Act: Legislative Recommendation of the ABA Tax Section Committee on S Corporations Approved by the ABA Tax Section (August 1989) Committee on S Corporations [Legislative Recommendation Project No. Leg–8837–004] to Promote the Adoption by the States of a Model S Corporation Income Tax Act.

Worksheet 4 Model S Corporation State Income Tax Act: Resolution Approved by the ABA House of Delegates (February 1990) American Bar Association Section of Taxation Report to the House of Delegates

Worksheet 5 Model S Corporation State Income Tax Act: Multistate Tax Commission Resolution

Worksheet 6 Model S Corporation State Income Tax Act: Multistate Tax Commission Hearing Officer's Report Report of the Hearing Officer on the American Bar Association Model S Corporation Income Tax Act (“MoSCITA”) with Six Proposed Modifications

Worksheet 7 Model S Corporation State Income Tax Act: Multistate Tax Commission Exhibit B to the Hearing Officer's Report (The Six Proposed Modifications)

Worksheet 8 S Corporation Return Filing Due Dates

Bibliography