The Multistate Tax Dilemma
Many of our clients who reside in California take ownership of an interest in an S Corporation, Partnership or Limited Liability Company that owns property and/or operates a business across state lines. Since the various ownership positions involve income tax filings in other states, there are income tax filing options to consider. For instance, will your pass-through entity file tax returns in multiple states on your behalf on a composite basis? If so, the operator of the business should consider the impact on your personal tax obligations in these states.
Shareholders and partners may be required to file a non-resident individual tax return for those states the pass-through entity is conducting business, absent the entity filing a composite tax return on the owner’s behalf. The simpler approach for the owner is to have the entity file the composite return for the benefit of its’ out-of-state owners. When a pass-through entity files a tax return, it can also elect to file a composite return and make a composite tax payment on behalf of the owners. The owners’ tax obligation is fulfilled and there is no paperwork burden on the owners’ part.
However, the details are a little more complex than that. There are a number of factors to consider when deciding whether composite tax is the right choice for you. For example:
1. Does the pass-through entity qualify to file a composite return?
In certain states, the entity must have a minimum number of participating nonresident owners to be qualified for composite filing.
2. Does the owner qualify to participate in a composite return?
In certain states, an individual would not be allowed to participate if they have income in that state from outside sources. For example, the owner has two K-1’s in that state, or, he has one K-1 in that state but also rental income from that state.
3. What does the owner risk losing from filing a composite return? Does the owner have any prior year suspended losses?
Some states may impose limitations or do not take into account standard deduction, state exemption, and state credits on a composite return. Prior year losses are typically not allowed on a composite return either.
4. Is the tax rate higher on composite returns?
Participating in composite returns may subject the nonresident income to the highest marginal tax rate applicable to individuals or at the applicable corporate tax rate. If the owner is subject to federal Alternative Minimum Tax (“AMT”), they would not be able to deduct the higher state tax paid on their composite returns. However, the higher composite tax liability in the non-resident state will likely be offset by increased tax credit on the owner’s California resident state income tax return because of California’s high tax rates.
5. Is audit exposure within the other states mitigated?
By having the composite returns filed on the California residents’ behalf, the audit exposure for other states may be shifted from the individual to the entity. It could further reduce the owner’s administrative burden of dealing with the tax authority.
These factors could greatly affect the state tax liability of an individual and are only part of the numerous issues to weigh in on when choosing to participate in composite returns. Circumstances vary in each situation. Also, when investing into managed funds through a pass-through structure, please be sure to evaluate the income tax complexities and compliance costs that may accompany such an investment. Many hedge fund partnerships and LLC’s operate in many states which can cause small allocations of out-of-state income which create tax exposure and compliance costs that exceed the investment returns allocated from other states by the fund manager.
If you have any questions regarding composite income tax filing, please contact our office at (949) 260-1430 for more information.
Written by Rachel Chen
SKINNER FOUCH & OLSON LLP