Multistate Tax Considerations for S Corporations
Many S corporations do business in multiple states and must file income or other tax returns in them. Many states have been more aggressive in going after out-of-state companies doing business in their states. Many of these businesses do not realize they have an exposure to a state’s taxes until they receive a nexus questionnaire from that state (see “Navigating Nexus,” JofA, Nov. 2010, page 48).
For CPA firms, the growth and expansion of these businesses create opportunities for additional tax compliance and tax planning services. States differ as to whether they recognize the S corporation as an entity for tax purposes, the method of electing S status, types of taxes assessed, apportionment formulas applied and other issues. Nevada, South Dakota, Washington and Wyoming do not have an individual or corporate income tax.
Recognition of S corporations as flow-through entities. The District of Columbia, New Hampshire, Tennessee and Texas tax S corporations in the same manner as C corporations, meaning they pay corporate income or income-related taxes. Louisiana taxes S corporations as C corporations, but allows them to exclude from taxable income the portion on which shareholders have paid Louisiana income tax. All other states recognize S corporations as flow-through entities for income tax purposes.
Recognition of the federal S election. For federal tax purposes, a corporation must file Form 2553, Election by a Small Business Corporation, to gain S corporation status. Most states follow the federal government in recognizing the S election. However, Arkansas, New Jersey and New York require a separate state S election.
Income apportionment. Multistate S corporations are allowed to apportion their income to the states with which they have nexus. For many years, most states followed an evenly weighted three-factor apportionment by sales, tangible property and payroll in each state.
Recently, states have been changing their apportionment formulas. Only 10 states now use the traditional evenly weighted, three-factor apportionment formula in all cases. Another four states allow it in some cases or allow optional use of an alternative method. The trend has been for states to assign a greater weight to the sales factor and less or no weight to property and payroll. Thus, states can shift the tax burden from in-state corporations to out-of-state corporations, which are less likely to have property in the state or pay workers there.
Type of taxation. Some states do not assess any entity-level tax based on income, net worth or capital value. Along with those without an income tax mentioned earlier, those states include Alaska, Arizona, Arkansas, Colorado, Florida, Hawaii, Indiana, Iowa, Maine, Maryland, Montana, North Dakota, Utah and Virginia. However, many states assess additional taxes on S corporations in the form of franchise taxes, business privilege taxes or other excise taxes based on gross receipts, income, net worth or capital value. An unusual example of an add-on tax is New Jersey’s per capita tax on shareholders of professional service firms. New Jersey refers to this as a filing fee assessed at $150 per shareholder. For additional information, see N.J. Rev. Stat. § 54:10A-18(c)(2).
Composite returns. Many states allow multistate S corporations to file a composite tax return on behalf of all shareholders of the S corporation. With it, the income of each shareholder is reported to the state, and the S corporation pays the tax on behalf of the shareholder. The advantage is that shareholders do not have to file individual income tax returns for that income with any state where the S corporation filed a composite tax return. The states that do not accept composite tax returns include Nebraska, Oklahoma, Tennessee and Utah (although Utah did issue a private letter ruling (02-033) in 2003 allowing a composite return for nonresident shareholders in an electing small business trust). Some states, including Arizona, New York and Vermont, restrict the use of composite returns, based on income or number of shareholders. Application of the highest tax rate to the shareholders’ income on a composite tax return is a disadvantage of composite filings.
Estimated taxes. Several states have an estimated tax requirement for S corporations, including Delaware, Kentucky, Maryland, New Jersey, New York, North Carolina, Oklahoma, Rhode Island and Wisconsin. In certain states, composite payments are treated as estimated tax payments.
Withholding on nonresident shareholders. For S corporations not filing composite tax returns, many states now require that state income tax be withheld for nonresident shareholders. Some states that still do not require withholding on nonresident shareholders include Alabama, Arizona, Connecticut, Delaware, New York, North Carolina and Vermont. Idaho began withholding effective this year. In addition, some states require S corporations to file nonresident shareholder agreements with their returns. Lacking an agreement, or failing to adhere to an agreement, the S corporation pays the tax at the maximum rate.
Federal return attached. Most states require some portion if not all of the federal Form 1120S, U.S. Income Tax Return for an S Corporation, to be attached to the state’s corporate tax return. Some states that do not require this are Colorado, Illinois, Louisiana, Tennessee and Texas.
Other considerations. An audit in one state may require filing amended returns in other states (by the S corporation, shareholders or both). Failure to do so may result in assessments, including interest and penalties, from the other states or a missed opportunity for a refund.
Many times, corporations make the S election so they can pass through anticipated losses to shareholders currently. If a shareholder’s resident state recognizes S elections, the pass-through of losses may be beneficial at the state level if the individual tax rate is greater than the corporate tax rate. Conversely, if the S corporation has profits, there is an advantage to filing an S election for that state if its corporate rate is higher than its individual tax rate.
Keeping up with 51 jurisdictions can be an onerous task for practitioners, and patience and perseverance is needed. To help practitioners stay abreast of tax laws for all jurisdictions, a tax research service with multistate tables, reference guides and newsletters can help. Because the costs and complexity of preparing and filing state corporate returns and the shareholders’ state personal returns for a multistate S corporation could be significant, helping businesses comply and plan strategically can be an opportunity for practitioners.
By C. Andrew Lafond, CPA, DBA, (lafond@tcnj.edu) assistant professor, The College of New Jersey, and Jeffrey J. Schrader, CPA, (jjscpa@fast.net) shareholder in Jeffrey J. Schrader, CPA, PC, Trenton, N.J.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.
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