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By James Kehl, CPA
Weil, Akman, Baylin & Coleman, P.A.,Timonium, MD
State and local taxation of S corporations is a tax practice that is becoming increasingly important. Like other business entities, an S corporation may be considered as doing business in more than one state. An S corporation conducting business in more than one state may be confronted with numerous tax issues due to the lack of uniformity in states' tax rules governing S corporations. The purpose of this Insight is to review some of those tax issues.
Lack of Uniformity Among States Concerning Taxation of S Corporations
Subchapter S of the Internal Revenue Code contains a set of rules that reflect the fact that, except for certain types of taxes (e.g., the built-in gains tax and passive investment income tax), an S corporation is not taxed as a separate entity for federal income tax purposes. Instead, the S corporation is a conduit that passes its items of income and loss through to its shareholders. However, some states do not recognize the federal S corporation election and may either tax the S corporation as a C corporation or impose additional requirements. In addition, there is a lack of uniformity in the tax treatment of S corporations among the states. This lack of uniformity may result in certain items of S corporation income being taxed more than once. In order to remedy this problem, a subcommittee of the American Bar Association has drafted the "Model S Corporation State Income Tax Act." The purpose of this Act is to provide a consistent approach by the states with respect to the tax treatment of S corporations and their shareholders. In general, the Act applies the federal tax laws concerning S corporations at the state level. However, many states have not adopted the Act. As a result, the lack of uniformity in the taxation of S corporations and their shareholders continues.
State Taxation of S Corporation Shareholders
States that recognize an S corporation as a pass-through entity may subject resident and nonresident S corporation shareholders to tax. A well-established Supreme Court precedent allows a state to tax resident shareholders on the entire amount of their shares of an S corporation's income, even if that income is not from sources within the resident state.1 Many states that tax resident shareholders in this manner allow the shareholders a credit that reduces the residents' state tax for all or a portion of the state income taxes to a nonresident state.
A state where the S corporation is not incorporated may be able to tax an S corporation and/or its shareholders on all or part of the S corporation's income if: (1) the S corporation has sufficient nexus to be considered as doing business in the state; (2) the S corporation maintains a place of business within the state; or (3) the S corporation derives income generated by property owned by the S corporation within the state. A state may also be able to impose franchise or other types of taxes on an S corporation that is either licensed or that qualifies to do business in the state.
A state that subjects nonresident shareholders to tax with respect to their shares of income earned by the S corporation within the state may require the S corporation to withhold and pay estimated taxes on behalf of those shareholders. These payments are customarily listed on a state form that is a facsimile of the federal Form 1120S, Schedule K-1. The important aspect of this treatment is that these state tax payments are treated as payments made by the shareholders and are not deductible by the S corporation as a state income tax expense. Rather, the payments are treated as payments of the individual shareholders' liabilities for their respective nonresident personal income taxes to the state. The correct accounting for these estimated tax payments is to treat them as distributions to nonresident shareholders. Given the single class of stock requirement, estimated tax payments on behalf of nonresident shareholders may require the S corporation to make equivalent distributions to resident shareholders.
Some states permit an S corporation to file a composite return on behalf of its nonresident shareholders and pay the tax applicable to the income of those shareholders reported on the return. The nonresident shareholders whose shares of S corporation income are reported on the composite return normally have to file a statement that is included with the composite return and states that the nonresident shareholders do not have any other income attributable to the state. A shareholder with a substantial amount of income attributable to the nonresident state may want to consider not participating in the composite return because the shareholder will not receive the benefit of any portion of the shareholder's itemized deductions that may be allocated to the state under the apportionment rules that would apply if the shareholder filed an individual nonresident state tax return.
Other State Tax Aspects
It appears that no state recognizes S corporation status if the corporation has not made an S election for federal income tax purposes. Some states may require an S corporation to file a separate state S election form with the state. Other states may impose conditions for making an S election that are different from the federal requirements.
Many states follow the federal statute with respect to Qualified Subchapter S Subsidiaries (QSUB). In states that impose franchise taxes, it is possible that the state may require a QSUB to pay a separate franchise tax. If a QSUB election is being considered, the tax adviser should verify if the inclusion of the QSUB's assets, liabilities, revenues or expenses as part of those items of the parent corporation causes the parent S corporation to be subject to tax in a state in which it previously did not have nexus. Further, a QSUB election may increase the parent S corporation's tax liability for a specific state because the sales revenues and payroll expense of the QSUB is added to those totals for the parent corporation.
States usually have modifications to federal taxable income. As a result, a shareholder may have a stock or debt basis for state tax purposes that differs from the shareholder's federal income tax basis.
Certain states require separate entities that are regarded as functionally integrated components of a unitary business to combine their income and apportionment factors in determining each entity's income attributable to the state. If only S corporations are combined, no particular allocation problems arise. Some unitary states, however, require unitary S corporations to combine with unitary C corporations. In this situation, the S corporation's shareholders (particularly minority shareholders) can be adversely affected, especially where the C corporation is significantly more profitable than the S corporation.
Apportionment of Income Issues
Any enterprise that conducts business in multiple states must deal with multi-state taxation issues. Most states require that a business calculate the amount of its income that is attributable to each state in which it conducts activities by using an apportionment formula. The percentages of an entity's sales, payroll and property owned in each state are computed. Those three percentages are then averaged. This average percentage is then multiplied by the entity's income to determine the amount of the entity's income attributable to each state.
The three-factor formula has generally been accepted by most states. In fact, many states do not allow a business to determine the amount of its income attributable to various states by any other method unless the taxpayer can clearly show that the income for each state calculated under the three-factor formula is distorted or unrealistic.
However, the three-factor formula was designed for a business in which payroll, sales and property are integral parts of a business. The formula probably arrives at a fair approximation of an enterprise's income allocable to each state for a manufacturing business. It probably does not arrive at a fair approximation of each state's income in the case of a service business. The primary reason that the three-factor formula may result in a distorted allocation of income is that property owned is often not a material income producing factor for a service business. In other cases, payroll may not be a material income producing factor, for example, if a service business utilizes independent contractors to perform its necessary services rather than employees. In these cases, states may allow the service business to weigh the sales factor more heavily or allow the business to use a single factor formula that is based on the percentage of the sales of the business in each state.
Differences in the tax treatment of S corporations among states often produce results that are unfair to S corporations and their shareholders. Until either the Model S Corporation State Income Tax Act or a similar proposal is adopted by all states, S corporations will continue to have to grapple with the problems caused by the lack of uniformity in state laws.
For more information, in the Tax Management Portfolios, see Starr, Smith, and Sobol, 730 T.M., S Corporations: Formation and Termination, and in Tax Practice Series, see ¶4390, Multi-State Taxation of S Corporations..
1 Cohn v. Graves, 300 U.S. 308 (1937).
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