Partnerships & S Corporations
Businesses structured as partnerships and S Corporations are allowed to file composite and withholding tax returns on behalf of owners since they are pass-through entities. When there are nonresident owners, many states allow the business to file an additional tax return to pay taxes on behalf of the nonresident owner.
What is a Nonresident Owner?
States have specific rules on what qualifies as a nonresident owner. Generally, owners are considered nonresident if their domicile or primary residence is outside the state. Nonresident owners include individuals, certain trusts, and estates.
What are Composite and Withholding Tax Returns?
Composite and withholding taxes are extremely similar with one big difference: 1 fulfills your personal state filing requirement and the other may not.
The words “may not” are confusing, what do you mean it may not fulfill my personal filing requirement? Because the distinction can be confusing, it helps to understand what composite and withholding taxes are. Composite and withholding taxes are income taxes paid by the business on behalf of its nonresident owners. The return calculates state taxable income and applies the state personal income tax rate to calculate income tax due. When a business pays these taxes, it’s deemed as a distribution to the owner – because they would have had to file that state return themselves and pay the taxes personally. These filings exist to simplify compliance for owners and ensure states receive income tax revenue from nonresidents with in-state earnings. A composite tax return is a consolidated state income tax return filed on behalf of multiple nonresident owners. States have slightly different sets of rules on whether the business can file a composite tax return, such as a minimum of 10 nonresident owners for Arizona.
While a withholding tax return is similar to the composite tax return, it does not fulfill the owner’s personal state filing.
Which One Fulfills My State Filing Requirement?
Composite tax filings fulfill your personal state filing requirement, while withholding returns assist with it.
For withholding tax, look at individual income tax nexus rules for each state to see if there is a filing requirement. If you have multiple sources of state income, then you will need to file the state return personally to properly report all sources (if the nexus threshold is met).
Important Considerations
Composite and withholding taxes can cause disproportionate distributions for S Corporations. If shareholders are state residents, then composite taxes are not paid by the S Corporation, but the nonresident shareholders are. A distribution true-up is required to see what is owed to the other shareholders to make distributions proportionate.
State income tax rates used on composite and withholding tax returns may be higher than if the owner filed the state return personally.
Article by: Ki Richardson, CPA
