Pass-Through Entities’ Tax Payments for Nonresident Owners.

Ensuring that nonresidents pay their share.

any states, in order to collect revenue without having to pursue nonresidents for it, have begun requiring flow-through entities (for example, S corporations, partnerships and limited liability companies (LLCs)) to either withhold taxes or pay estimated taxes on behalf of their nonresident shareholders, shareholders, partners and members (owners), respectively. This requirement can create economic, contractual, statutory and administrative problems for CPAs and their clients, and so is worth scrutiny.

The most basic issue is the economic one—does the entity have the available cash flow to make the required payments? If not, in extreme situations, a pass-through entity may have to secure additional financing or ask those affected to contribute more capital.

The next problem is contractual—does a third-party contract or an agreement bar payments on nonresidents’ behalf (for example, a shareholder agreement, partnership agreement or LLC operating agreement)? Many financing agreements limit or bar distributions to (or on behalf of) owners in the absence of certain conditions. Agreements with regulatory or state funding agencies similarly place restrictions on distributions.

Many agreements call for distributions based on the “class” of owner. A violation of the agreement may occur if the entity must make distributions on behalf of certain shareholders/partners/members due to their status as nonresidents before making distributions to those with a higher priority.

Statutes can pose additional problems. S corporations, for example, have to make distributions in proportion to stock ownership. Thus, if a company makes estimated/withholding tax payments on a nonresident shareholder’s behalf and treats them as distributions, it must make proportionate distributions to the remaining shareholders.

However, the entity’s cash flow may be inadequate to permit distributions to all shareholders. Some tax advisers treat the tax payments as loans to the nonresident owners, which they can repay either from future distributions or directly. The treatment of payments also varies from state to state.

Tracking the residency status of shareholders/partners/members can be an administrative nightmare for a flow-through entity. It may not be able to rely on an owner’s mailing address to determine state of residence. Pass-through entities may have to inquire specifically as to state of residence.

CPAs, who represent pass-through entities with nonresident owners and/or nonresident owners of pass-through entities, need to be aware of all of the foregoing issues.

For more information, see the Tax Clinic, edited by Allen Beck, in the October 2003 issue of The Tax Adviser.

—Lesli Laffie, editor
The Tax Adviser

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