Most pass-through entities (“PTEs”) 1 are usually aware that tax is due on the income earned in the state by the ultimate owner of the entity.2 PTEs owned by other PTEs or corporations (entities) pose an interesting challenge because the requirement for tax compliance for entities varies greatly from individual non- resident owners. Entity owners may be treated as non- residents by definition, even if the entity does business in the state in another capacity. Businesses should not assume that tax treatment is equal regardless of ownership.
State taxing authorities only have the ability to enforce their state’s laws on taxpayers that are residents of the state. When a PTE is owned by a non-resident individual, its ability to collect applicable state income taxes from the non-resident may be jurisdictionally limited. Instead, states rely on the PTE itself to self-regulate and properly remit income taxes due from a non-resident owner.
Most states fall into two tax collection structures: withholding or composite. The withholding tax structure requires the entity to remit withholding tax on behalf of the owner. In most cases, the PTE will treat this as an owner distribution for accounting purposes, as this payment is not a deductible business expense. The individual owner is generally obligated to file its own return in the state to report any available deductions, exemptions, and tax credits, and to either claim a refund for taxes withheld in excess of its obligations or pay any shortfall. In cases of multiple owners, this can result in many tax returns being filed at the ownership level.
The composite tax structure allows the PTE to file a single return on behalf of all its owners, thereby relieving owners from the requirement to file separate returns. In cases of multiple owners, this can result in a significant reduction to tax compliance. All applicable taxes are paid by the entity on a single composite return for qualifying owners.3 Like withholding payments, these amounts are typically treated as a distribution for accounting purposes, although this accounting treatment is not required. Alternative treatment may include loans to owners or require reimbursement from the owners.
Similar rules can apply when the owner is an entity instead of an individual. To complicate matters further, states can differ on their treatment of entity owners depending on the tax treatment of the entity itself.
Withholding Tax Challenges
While it may sound simple to withhold tax on an owner’s income, in reality the compliance may not be as straightforward. First, withholding tax requirements may not apply in instances where income or tax due is below a specific threshold. This threshold can be applied to the entity as a whole or to a specific owner. For example, Michigan requires PTEs with Michigan-sourced business income of over $200,000 to withhold on behalf of owners that are PTEs or corporations.4 The $200,000 threshold is determined at the PTE level and not on a per-owner basis.5 In other states these thresholds may be as low as $500 or $1,000.
The rate of withholding can vary depending on the type of owner. Withholding on individual owners is usually a flat rate, often the highest marginal rate in states that apply a graduated individual rate. Withholding on corporate owners is usually the statutory corporate rate. When the business is owned by a PTE, the requirement to withhold may depend on the ultimate owner. For tiered entity structures, this may require the lower-tier entity to look through many upper-tier entities to determine whether any withholding is due as well as the applicable rate. For example, Michigan requires withholding for both PTE and corporate owners at the full 6% corporate rate. If the PTE knows the ultimate owner of the upper-tier PTE is a non-resident individual, it may instead withhold at the individual rate, currently 4.25%.
Withholding in itself may not be compulsory. Certain types of entity owners may be exempt from withholding requirements, such as trusts, which may take many forms. Of particular note are grantor trusts, which are treated as disregarded and take on the tax form of the grantor. If the grantor is an individual, the pass-through income is reported by the individual, but withholding may not be required because the trust is an entity and not an individual in the state’s opinion. Ultimately, this may result in the need to pay estimated taxes at the individual level to avoid under-withholding and penalties.
The requirement may also depend on the pass- through entity itself. Some states require withholding on S-corporations but not partnerships or LLCs, or vice versa.6 Other states specifically exempt publicly traded partnerships or trusts from any withholding requirements.
Withholding may also be purely voluntary at the option of the PTE or its owners. However, PTEs may wish to withhold on behalf of their non-resident owners as this avoids the need to pass sensitive income information to the owners for purposes of computing estimates. Although this can lead to over-withholding, it is often the simplest method when an owner’s only in-state activity is the income from the pass-through entity.
To further complicate the matter, some states allow owners to explicitly elect out of withholding. Such elections usually require a waiver form signed by the non-resident owner. These waivers may be in effect perpetually until revoked in writing or may need to be renewed every year. The majority of states require these waivers be in the PTE’s internal bookkeeping at the time the tax return is completed and do not require submission to the state. In the states that require submission or approval, practitioners should be careful to monitor the due dates of these waivers, as certain states do require the signed election to be submitted either at the beginning of the year or with the filing of the tax return itself. 7 Failure to remit applicable withholding can result in penalties for the PTE.
Owners may not desire to have the PTE withhold for a number of reasons. Acommon example is where the owner has other activities in the state resulting in losses that offset the PTE income. If the owner knows that ultimately no tax will be due, this can reduce cash outflows of the entity. Second, the owner may already be making estimated tax payments due to other activities, and withholding at the PTE level may result in duplicative payments. The other major reason is the preference or requirement to file a composite return instead of withholding.8 When it comes to tiered PTEs, entities must be cognizant of the withholding completed by other entities in the structure. In some cases, the state may require withholding at every tier in the structure, thereby duplicating payments. In these cases, owners should evaluate their withholding needs and, if allowed, determine if they should elect out.
There are, of course, risks to the withholding regime. First, the withholding may be insufficient to cover the amount of tax due. This arises in cases where the withholding rate is lower than the owner’s effective tax rate. This can also be attributable to differences in apportionment methodologies between the business and the owner.9 Multi-tiered entities run the highest risk of under- withholding. Under-withholding arises when a lower-tier entity may have losses, but the weighting of factors at the upper-tier level results in additional tax due.
Basis and Timing of Withholding
The next relevant question is how much to withhold. In most states, withholding is required on the non-resident owner’s distributive share of income – essentially the income reported on the state K-1. Whether that income is actually distributed in cash or property is not considered.
The timing for making estimated payments is yet another deadline to monitor. States can require quarterly estimated payments based on the distributive share of income. Like other tax types, these estimates can be safe-harbored based on prior year or current year income requirements. In certain states, estimates of withholding tax can also be annualized for purposes of penalty and interest management. If an entity’s income is seasonal in nature, it may wish to apply annualization principles to manage its cash flow. Other states only require payment of withholding once per year, usually with the filing of the return or extension.
One of the difficulties around withholding payments has nothing to do with state-imposed requirements, but with legal requirements surrounding the PTE itself. S-corporations must be cognizant of proportionality for tax distributions. Distributions made to owners must be made on a basis proportionate to ownership, otherwise the S-corporation runs the risk of inadvertent termination of its S-election.10 This comes into play primarily under two possible scenarios. The first is when owners are residents of multiple states. Participation in withholding is limited to non-residents. For example, suppose a PTE files a return in California, and has one owner who is a resident of California and one who is a resident of Oregon. The California owner does not participate in the withholding scheme; only the Oregon resident may participate. If the PTE only makes a withholding payment to California on behalf of the Oregon owner without making a corresponding cash distribution to the California owner, this results in a disproportionate distribution.
The other common scenario is when the PTE is owned by different types of entities under different withholding regimes. For example, suppose an S-corporation is owned by a grantor trust and an individual and does business in a state that requires withholding only on individuals and not on grantor trusts. When the withholding is paid for the individual, a similar proportionate withholding tax distribution must also be made to the grantor trust. Many PTEs overlook the need for parity.
In particular, S-corporations must be wary when there is a change in ownership during the year. Tax payments made after the close of a tax year are often made on behalf of an owner who has exited or may not be entitled to further distributions. This should be taken into account when the buy-out or other liquidation agreements is drawn up for the exiting shareholder. Because distributions are treated on a cash-basis accounting method, this can result in tax distributions made to non-owners in the year after exit, which need to be remedied.
Partnerships have similar issues with adherence to their partnership agreements. Partnership agreements may require tax distributions be made on a pro-rata profit or equity basis. More complex agreements may restrict distributions to certain partners until other partners have recovered certain income or cash-flow targets. Because partnerships allow for great flexibility in allocations of both income and distributions, practitioners should carefully review agreements to ensure that tax payment recommendations are not in violation. Another recommended course of action would be for the agreement to specially allow for tax distributions to be made according to federal and state law without regard to other specific allocation restrictions within the agreement itself.
Decision-making around withholding compliance brings up more complexity than what may appear at the surface. Keeping open lines of communication between businesses and practitioners is paramount in ensuring applicable taxes are paid timely and sufficiently to cover an owner’s tax liability. Tiered entity structures bring extra layers of complexity to an already convoluted area, and businesses should be aware of the implications of their own withholding preferences in addition to the state’s statutory requirements.
JoAnna Fu Simek at BKD, LLP