Pass-through entities may not be totally “passthrough” anymore, even though they remain largely untaxed at the entity level. As pass-through entities are impacted by the current economic environment and as states more aggressively pursue tax collections, attention to new state taxing initiatives is warranted.  

Effective for years ending on and after December 31, 2008, Illinois, like more than two-thirds of all states, now requires partnerships, S corporations, LLCs and trusts to withhold and pay state income taxes on behalf of their non-resident owners’ shares of taxable income. This responsibility is imposed upon pass-through entities doing business in the taxing states (with narrow statutory exemptions), regardless of the state of their organization.  

States are obviously requiring payments by these entities in an effort to plug a leak in collections from non-resident taxpayers who may not feel a strong obligation to file a return and pay a tax to a state with which they have no other connection. Generally the tax is also payable on account of owners who are foreign nationals, as well as U.S. residents of states other than the one where the entity is doing business. Among the states that take this approach are Michigan (as of October 1, 2003) and California (as to tax years beginning on or after January 1, 2005).  

These tax laws vary from state to state, but they all impose new liabilities as well as additional bookkeeping and accounting expenses upon passthrough entities. These states require payment by pass-through entities, but not all require the entities to withhold from cash distributions to non-resident owners. As a practical matter, however, pass-through entities should reserve sufficient funds to avoid having to seek reimbursement from owners for taxes paid on their behalf and to avoid other adverse consequences described below.  

Many S corporations make distributions to shareholders at least in amounts estimated to be sufficient to pay taxes on taxable income “passed through” to the shareholders. Paying state taxes for a shareholder is technically making a distribution, and since S corporations must make proportionate distributions to all shareholders, they must make distributions to resident shareholders when they pay taxes on behalf of non-resident shareholders. While LLCs and partnerships are not required by law to make proportionate distributions to all owners, they customarily are required by their governing documents to make defined distributions, and paying taxes for one group of owners may require compensating cash distributions to others.  

Under the relatively new state tax requirements, a cash problem could confront pass-through entities that generate no cash from which to make distributions but nevertheless generate taxable income. For instance, a foreclosure of real property or depreciation in excess of basis could generate “shadow” income subject to income tax but might not generate cash flow. Such a pass-through entity remains liable for state income tax due from nonresident owners. If the entity has funds to pay the tax but not to make other distributions, the resident owners are economically disadvantaged, and an S corporation could be making a fatal disproportionate distribution. If cash reserves are exhausted and the general partner of a limited partnership is required to pay any remaining tax due from non-resident limited partners, there is a similar injustice to the general partner and to resident limited partners.  

In response to the law in Illinois and similar laws elsewhere requiring pass-through entities to pay their non-resident owners’ tax liabilities, these entities should review their governing documents. Where necessary to avoid unintended economic disadvantages among owners and resulting disputes, governing documents should be amended to accommodate the need to withhold and pay state taxes, to maintain additional reserves, to provide for possible cash contributions to pay taxes and to make equalizing distributions before other proportionate distributions can be made. It is time to review all partnership agreements, both general and limited, LLC operating agreements and S corporation shareholder agreements and bylaws before cash flow shortages become imminent.