As 2015 comes to a close, pass-through entities doing business in multiple states must take stock of their compliance obligations to file returns and pay tax in those states. Doing so requires determining if they must file composite returns, withhold, or remit estimated taxes to ensure that nonresident owners pay tax on their distributive share of income allocable to the various states in which the entity does business. Even after identifying the applicable filing or payment mechanisms, pass-through entities must wade through an assortment of thresholds and differing requirements for corporations and individuals.
Approximately three-quarters of states that impose individual and corporate income taxes require pass-through entities doing business in the state and having taxable income derived from sources within the state to withhold tax with respect to a nonresident owner's share of that income. Withholding requirements provide a means for taxing the income earned by a pass-through entity in the state when personal jurisdiction over the nonresident owner may be limited. Most states also require withholding in the absence of a distribution of income to a nonresident owner.
States often describe the pass-through entity's obligation in terms of making estimated tax payments on behalf of the nonresident owner or treat the nonresident owner as having made the payment for its own account. Requirements to make estimated tax payments on behalf of nonresident owners or to withhold with respect to allocated rather than distributed income can create cash-flow issues for pass-through entities to accompany their state tax compliance obligations.
A number of states provide exceptions from the withholding requirement if a pass-through entity files a composite return that includes nonresident owners or if nonresidents submit written consent to a state taxing jurisdiction and agree to pay tax on their distributive shares of the pass-through entity's income. States like Illinois and Utah, however, no longer accept composite returns but mandate withholding in order to collect taxes on income derived from in-state sources. As outlined in Utah Publication 68, a pass-through entity must withhold 5 percent tax on both business and nonbusiness income derived from or connected with Utah sources and allocated to nonresident owners, whether individuals, other pass-through entities or C corporations.
Pass-through entities doing business in multiple states face the challenge of understanding the compliance obligations in each state. Withholding may not be required if income or tax due is below a specific threshold, which may be applied to the entity as a whole or to a specific owner. New York, for example, provides an exception if the amount of tax with respect to a specific owner is not greater than $300. Many other states do not require withholding if a nonresident owner's share of income is less than $1,000 or $1,500.
Michigan, in contrast, has a much higher threshold for withholding from the income of corporate owners. A pass-through entity with business activity in Michigan is not required to withhold tax from a corporate member unless the pass-through entity reasonably expects to accrue more than $200,000 in business income for the tax year, after allocation or apportionment to Michigan. The $200,000 threshold is determined at the entity level and is not a per member threshold.
The rate of withholding can vary from state to state depending on the type of owner. Withholding with respect to individual owners is generally at a flat rate and equal to the highest marginal rate in states that have a graduated individual rate. Withholding on corporate owners is usually at the statutory corporate rate. For tiered entity structures, a lower tier pass-through entity may be required to look through several upper tier entities to determine whether any withholding is due and the applicable rate. For example, Michigan requires withholding for both pass-through entity and corporate owners at the 6 percent corporate rate. If the entity required to withhold knows the ultimate owner of the upper tier pass-through entity is an individual, it may withhold at the 4.25 percent individual rate.
Another complication arises in states that allow owners to elect out of withholding by requiring the nonresident owner to sign a waiver form. Waivers may be in effect until revoked in writing or may need to be renewed each year. Most states require the pass-through entity to keep these waivers with its other tax return supporting documents and produce them upon request. Other states may require submission or approval of the waivers and pass-through entities will have to keep track of filing due dates.
In the event of cash-flow problems or other hardship, a pass-through entity may seek an exemption from the tax withholding obligation. In Virginia, for example, a pass-through entity seeking an exemption on the basis of undue hardship generally must petition the tax commissioner by letter explaining the facts and circumstances creating the hardship. The pass-through entity also must provide sufficient information to enable the taxing authority to compare and evaluate the cost to the pass-through entity of complying with the withholding requirements and the cost to the commonwealth of collecting income tax from any nonresident owners who do not voluntarily file income tax returns and pay the tax.
In contrast to revenue raising activity in other states, legislation in Kansas eliminated the requirement that pass-through entities withhold tax from nonresident owners, effective July 1, 2014. The 2014 legislation followed legislative activity in 2012 that exempted from Kansas personal income taxation non-wage business income for pass-through entities. Kansas has taken steps more recently to fill a revenue shortfall, as reported by Christopher Brown in the June 16 Daily Tax Report, by requiring that guaranteed payments from businesses are counted as income. No move has been made yet to reinstate the withholding requirement.
Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: What compliance issues have you found to be particularly challenging for pass-through entity clients with tax withholding obligations?
More information relating to state pass-through entity withholding requirements is available in Bloomberg BNA's Corporate Income Tax Navigator and state requirements are easily compared using the Navigator's Chart Builder. Sign up for a free trial of the Bloomberg BNA Premier State Tax Library, a comprehensive research service that delivers deep, unique analysis, and time-saving practice tools to help practitioners make well-informed decisions.
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