The taxation of pass-through entities should be an area of increasing interest. On a national level, S corporations have long accounted for the majority of corporate tax filings, and the average annual increase in filings by partnerships and entities electing to be treated as partnerships (including limited liability companies electing to be taxed as a partnership for federal income tax purposes) has increased at a faster pace than that of incorporated businesses.1 More compelling, the percentage of pass-through entities filing Pennsylvania tax returns has increased annually between 1991 and 2015 from about 42% to 77% partly due to Pennsylvania’s personal income tax rate remaining significantly lower than its corporate rate.2 As the number of pass-through entities relative to traditional C corporations continues to increase, it’s important to be aware of the state and local tax issues impacting them, including recent developments.
Most states require pass-through entities to withhold state income taxes on behalf of their nonresident owners based on their distributive share of income in the state, but the withholding requirements vary. Some require withholding on nonresident individuals and trusts; others may require it for all owner types, including other pass-through entities or C corporations. Some only require partnerships to withhold on behalf of nonresident partners, while withholding may not be required by S corporations on behalf of their shareholders. Other rules include different apportionment methodologies for calculating nonresident income subject to withholding as well as different tax rates for purposes of calculating nonresident withholding liabilities. The differing state rules demand close attention.
Pennsylvania requires partnerships and S corporations to withhold tax if the nonresident is an individual, estate, or trust. Pennsylvania may require the pass-through entity to withhold on a corporate partner if it does not file its own Pennsylvania corporate tax report.3 There is no requirement to withhold on behalf of nonresident partnerships or S corporations. All taxpayers are subject to the same flat Pennsylvania income tax rate of 3.07% for individuals and 9.99% for C corporations.
While Pennsylvania doesn’t require nonresident withholding on partnerships or S corporations, New Jersey does require withholding on behalf of all nonresident partners’ share of tax, regardless of whether the partner is an individual or a pass-through entity.4 Unlike Pennsylvania, New Jersey imposes a graduated tax rate for purposes of calculating nonresident withholding tax owed. For example, the 2020 withholding rate for corporate and partnership owners is 9%, while the withholding rate for individuals, estates, or trusts is 6.37%. It’s important to note that the highest individual tax rate is 10.75% and the highest corporate rate is 10.5%. New Jersey uses the corporation business tax (CBT) allocation methodology for purposes of withholding and the gross income tax (GIT) allocation methodology for purposes of determining distributive share income.5 In contrast, New Jersey uses federal K-1 data, as opposed to New Jersey distributive share income, as the base for the nonresident withholding calculation.
The disconnect between calculating distributive share income and withholding can result in partners being overwithheld or underwithheld.
Certain states provide exceptions to nonresident withholding requirements and, in many, a pass-through entity can be released from its obligation to withhold taxes on nonresidents. Two common exceptions are if a nonresident owner consents to be taxed in the state or if the nonresident owner’s state source income is below a de minimis threshold. Neither New Jersey nor Pennsylvania provide such an exception.
As a general rule, pass-through entities are not taxed at the entity level, though there have historically been a number of state and local exceptions. Regional examples include Philadelphia’s business income and receipts tax (BIRT), unincorporated business taxes in New York City and the District of Columbia, and business privilege taxes imposed by Pennsylvania localities.6 As a result of the Tax Cuts and Jobs Act, a number of states enacted pass-through-entity-level taxes intended to function as a work-around to the $10,000 deduction limitation imposed on individuals.7 This past January, New Jersey joined a handful of states in creating a mechanism whereby a pass-through entity can pay an entity-level income tax on behalf of its owners.8 The business alternative income tax (BAIT) allows pass-through entities to elect to pay tax at the entity level for tax years beginning on or after Jan. 1, 2020. A pass-through entity is defined as a partnership, an S corporation with a valid New Jersey S corporation election,9 or an LLC classified as a partnership for federal income tax purposes. If the pass-through entity elects to participate, then it would pay tax due on the owner’s distributive share proceeds. The owners then claim a credit against their GIT liability for the amount of their distributive share of tax paid by the pass-through entity. Nonresidents may take a credit for taxes paid by participating in a composite return. Corporate members take a credit against their business tax.
To make an election, all owners of the pass-through entity must consent or any authorized person (such as a partnership representative) can make the election on behalf of all owners. At least one pass-through entity owner must be subject to the New Jersey GIT on their share of distributive proceeds. The election must be made on an annual basis, and it must be filed prior to the pass-through entity’s original due date. Quarterly estimated payments are also required. New Jersey has clarified that taxpayers will not be penalized for failure to file or make payments during the first year of the tax.10
Nonresident Credit for Taxes Paid to Other States and Localities
State and local complexities exist for individuals taxed on pass-through income earned from a multistate business. In general, a resident can claim a credit for taxes paid to another state. The issue becomes more complex when applied to a state granting credit for a local (nonstate) tax, or vice versa. It is further complicated when the tax paid was at the entity level, as opposed to being directly paid by the individual.
The U.S. Supreme Court addressed the issue of double taxation in Comptroller of the Treasury of Maryland v. Wynne. The case dealt with an individual’s pass-through income earned as the result of an ownership interest in an S corporation and the ability to claim a credit for taxes paid to other states. The court ruled that Maryland’s lack of a resident credit for taxes paid to other states against the state’s local personal income tax was unconstitutional because it discriminated against interstate commerce.
While not specifically addressing income from pass-through entities, there is litigation pending on this issue in Pennsylvania. In 2019, the Philadelphia Tax Review Board and the Philadelphia Court of Common Pleas denied an attorney living in Philadelphia and working in Wilmington, Del., a credit against her Philadelphia resident wage tax liability for taxes paid to the state of Delaware.11 This case has been appealed to Commonwealth Court.
While states such as Maryland and New Jersey12 have released comprehensive guidance on claiming credit for taxes paid to other local jurisdictions, others may differ with respect to their level of acceptance and available guidance, so filing positions should be carefully considered.
What we outlined above highlights both the complexity and importance of issues that pass-through entities already face. Additional items to consider include the states’ responses to decreased revenue resulting from the COVID-19 pandemic. States may consider implementing new tax legislation that makes the pass-through entity choice less attractive, or there could be an increase in state tax examinations. Additionally, under a new Bipartisan Budget Act (BBA) audit regime, the IRS now has the authority to collect assessments directly from the partnership rather than its partners. Additionally, these assessments are payable by the partnership in the year the assessment is issued, and not necessarily in the year which it was reviewed. One nuance is the possibility that the liability could be paid by partners who had no interest in the partnership for the years that were assessed. As of Jan. 1, 2020, a handful of states have enacted legislation addressing their conformity to the new federal BBA audit regime.13 Finally, taxpayers should consider allocation and apportionment implications, including, but not limited to, the sourcing of sales from services.14 Practitioners should continue to closely monitor state actions affecting pass-through entities.
1 Brett Collins, “Projections of Federal Tax Return Filings: Calendar Years 2009-2016,” Internal Revenue Service. www.irs.gov/pub/irs-soi/10winbulreturnfilings.pdf
2 The Statistical Supplement for the Pennsylvania Tax Compendium, Fiscal Year 2018-2019, Pa. Department of Revenue, p. 11. www.revenue.pa.gov/GeneralTaxInformation/News%20and%20Statistics/ReportsStats/TaxCompendium/StatSupplement/Pages/default.aspx
3 72 Pa. Stat. Section 7324; 61 Pa. Code Section 9.11; 72 Pa. Stat. Section 7403.2.
4 N.J. Rev. Stat. Section 54:10A-15.11.
5 Schedule J, Form NJ-1065; Schedule NJ-NR-A, Form NJ-1065.
6 There are other states and localities that impose an entity-level tax on pass-through entities. Some notables are New Hampshire’s net profits tax, Ohio’s commercial activity tax, Oregon’s corporate activity tax, and Texas’ franchise tax.
7 Matthew DiDonato, Bridget McCann, and Drew VandenBrul, “SALT Alert: New Jersey Enacts Elective Alternative Business Income Tax for Pass-Through Entities as Workaround to SALT Deduction Cap,” Grant Thornton LLP, Feb. 11, 2020.
8 Connecticut’s pass-through-entity-level tax is mandatory. Other states with an elective pass-through-entity-level tax include Louisiana, Maryland, Oklahoma, Rhode Island, and Wisconsin.
9 N.J. Rev. Stat. Section 54:10A-5.22; New Jersey Administrative Code Section 18:7-20,1. New Jersey requires a federal S corporation to make a separate election to be treated as a New Jersey S corporation.
10 Notice: Gross Income Tax/Corporation Business Tax Pass-Through Business Alternative Income Tax, N.J. Division of Taxation, Feb. 28, 2020. https://state.nj.us/treasury/taxation/baitpte.shtml
11 Zilka v. City of Philadelphia Tax Review Board, No. 1063 CD 2019, 1064 CD 2019.
12 Maryland Income Tax Administrative Release No. 42, Md. Comptroller’s Office, March 2019; and New Jersey Publication GIT-3-B, N.J. Division of Taxation, Dec. 2019.
13 Eileen Reichenberg Sherr, CPA, CGMA, “Why States Should Adopt the MTC Model for Federal Partnership Audits,” The Tax Adviser, March 1, 2020. www.thetaxadviser.com/issues/2020/mar/multistate-tax-commission-federal-partnerships.html
14 See, e.g., Synthes USA HQ Inc. v. Commonwealth of Pennsylvania, No. 108 F.R. 2016, Pa. Commonwealth Court, June 11, 2020. See also, SALT Alert: Pa. Commonwealth Court Upholds Department of Revenue’s Benefits-Received Sourcing Method for Pre-2014 Sales of Services, Grant Thornton LLP, August 2020.
Gregory M. Rineberg, CPA, is a manager, state and local tax, at Grant Thornton LLP in Philadelphia. He can be reached at email@example.com.
Bridget McCann, CPA, is a managing director at Grant Thornton LLP. She can be reached at firstname.lastname@example.org.