Corporate Close-Up: Common Questions Regarding the State Tax Treatment of Pass-Through Entities

One of the main challenges for practitioners in the multistate tax arena is the lack of guidance on important compliance issues. This is especially so for issues involving pass-through entities.  Questions include:

  • whether an ownership interest is sufficient to create nexus for a nonresident individual or nondomiciliary corporation;
  • whether classification of an entity's income as business or nonbusiness income is made at the entity level or owner level; and
  • whether a state takes an aggregate or flow-through approach, rather than an entity approach, to the apportionment of business income.

Below is a primer on each of these gray areas.


Legal Ruling 2014-01 (July 22, 2014) from the California Franchise Tax Board establishes that every member of multi-member LLC (treated as a partnership) doing business in California is also deemed to be doing business in California.  In Swart Enterprises, Inc. v. California Franch. Tax Bd., No. 13CECG02171, 2014 BL 369879 (Cal. Super. Ct. Nov. 14, 2014), a California court carved out an exception for an out-of-state corporate investor in a manager-managed LLC because the investor was not personally liable for the LLC's obligations, played no role in management and could not act as agent for the LLC or bind it in any way.

Two questions for all states are whether ownership of a pass-through entity interest creates nexus for the owner and does nexus depend on the owner's involvement in management or protection from liability.

Business or Nonbusiness Income

California, Illinois, Arizona and Pennsylvania are among the states that have addressed the issue of whether income is classified as business or nonbusiness income at the entity level or owner level.  California (Cal. Code Regs. tit. 18, § 25137-1(a)) and Illinois (Ill. Admin. Code tit. 86, § 100.3500(b)(1)) require that determination to be made at the entity level, but Arizona (Ariz. Rev. Stat. § 43-1412) and Pennsylvania (61 Pa. Code § 153.29(c)) require owners to classify the income.

States like California and Illinois generally attribute nonbusiness income to the state considered to be the source of the income, usually where the owner of a pass-through entity is domiciled, unless the owner has attained a business situs in the state.  In states that classify income at the owner level, a corporate investment in a pass-through entity may be treated as an intangible asset and income derived from the entity is separately allocated.

But in many states it’s unclear how the business/nonbusiness income determination is made.  A corollary question is whether states consider income derived from a pass-through entity to be business income unless proven otherwise. 


Under the aggregate or flow-through approach to apportionment, pass-through entity income is aggregated with a corporate owner's business income.  The total business income is then apportioned using a formula that combines the owner's distributive share of the entity's factors with the corporate owner's factors.

The entity approach treats a pass-through entity as separate from its owners.  A corporate owner with business activities in the same state as the pass-through entity computes its own state-apportioned income and adds the result to its distributive share of the entity's income determined separately.

A question for state revenue departments is what approach does it take in  apportioning the business income of a pass-through entity, and whether flow-through apportionment applies only if the entity and a corporate owner are engaged in a unitary business.  

Tax Withholding

The majority of states impose withholding at the source on pass-through entities and nonresident owners.  These rules are subject to numerous exceptions and exemptions and frequently changing.  Illinois, for example, began requiring, in taxable years ending on or after Dec. 31, 2014, tax withholding on nonbusiness income allocated to Illinois in addition to withholding on business income apportioned to the state (35 ILCS 5/709.5(a)).

Among the basic compliance questions that arise are  whether pass-through entity withholding is mandatory, whether the requirement applies to all types of owners (individual, corporate or other entities), how the withholding applies to tiered structures, and what exceptions apply.

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: What questions would you pose to state tax departments about the taxation of pass-through entities and their owners?

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