State Tax Considerations of an S Corporation
By Tom Corrie, Principal, Tax & Business Services & Christian Burgos, Managing Principal, Tax & Business Services
In general, the earnings of a corporation are often taxed twice both at the federal level and at the state and local level. Ordinary corporations, commonly known as Subchapter C corporations (or “C corporations”) are taxed on their income at the entity level, and should the corporation’s income be distributed to its shareholders via a dividend distribution, such income is taxed again at that level.
The possibility of this “double taxation” is often avoided by electing to be taxed as an S corporation. In 1958, Congress enacted the Subchapter S provisions of the Internal Revenue Code (“IRC”) to allow small corporations the benefits of the corporate form, such as limited liability, without being subject to double tax. The requirements that must be met to make an “S corporation” election are set forth in the IRC and are beyond the scope of this article. For federal income tax purposes, once S corporation status is elected, income and losses incurred by the entity pass directly to the shareholders and, as a result, typically corporate level taxes are avoided.
Although the federal tax treatment of S corporations is well-established, state treatment of S corporations varies widely. There are generally 4 approaches with regard to state tax treatment of S corporations:
- States which unconditionally recognize the federal S corporation election, adopt the flow-through nature of S corporations, and impose no entity-level tax on the S corporation.
- States which condition their S corporation recognition on certain shareholder elections and/or consents.
- States which do not recognize S corporation elections and tax S corporation as general corporations.
- States which recognize federal S corporations on a limited or modified basis.
For states that recognize S corporations, there is no uniform procedure for approving S corporation elections at the state level. The majority of states automatically accept the federal S corporation election. However, a number of states, such as Arkansas, New Jersey, and New York, require a separate state election to effectuate the status change to an S corporation. Further, other states, like Georgia, require specific consent from all shareholders who are not residents of Georgia to permit a corporation to elect S corporation status.
Not all states and localities recognize S corporations and, consequently, do not extend the pass-through taxation advantages to them since they treat them as C corporations. The District of Columbia, New Hampshire, Tennessee, New York City and Texas do not afford special treatment to S corporations. Similarly, Louisiana taxes S corporations as C corporations, but allows an exclusion regarding the portion of income with respect to which Louisiana shareholders pay income tax.
Even with regard to states that treat S corporations as pass-through entities, certain privilege or excise taxes may be applicable. For example, Alabama imposes a business privilege tax on an S corporation’s taxable net worth. S corporations in California must pay the greater of an $800 minimum tax or a 1.5% corporate franchise tax on income. Illinois imposes a 1.5% personal property replacement tax on S corporations. Ohio imposes a 0.26% commercial activity tax on an S corporation’s annual gross receipts. Rhode Island requires S corporations to pay a franchise tax based on capital, the minimum of which is $500. Similarly, in Pennsylvania S corporations are subject to a capital stock tax based on the entity’s capital stock value. Washington subjects S corporations to its business and occupation tax, if the corporation engages in certain types of business activities in the state. Moreover, West Virginia currently imposes a business franchise tax on S corporations, though it is scheduled to be repealed in 2015.
Once an S corporation begins doing business, the resident state of each shareholder will generally tax the entire amount of the shareholder’s percentage of corporate income, allowing a credit with respect to taxes imposed by other states on such income. In other states where the S corporation has nexus but has no resident shareholder, income is only taxed to the extent of that it is attributable to sources within the state. To ensure tax compliance by nonresident S corporation shareholders, many states require the filing of composite tax returns or impose tax withholding obligations.
A composite return is a single filing whereby participating shareholders report their pro rata share of S corporation income and the S corporation pays the state tax on behalf of the nonresident shareholders. While many states prefer the use of composite returns for nonresident shareholders, Nebraska and Tennessee, for example, do not accept composite filings. Moreover, some states, such as Arizona and Vermont, restrict the use of composite returns based either on income thresholds or the number of corporate shareholders.
Another technique to ensure tax compliance is requiring S corporations to withhold and remit tax on nonresident shareholders’ pro rata share of income. The amount withheld is generally equal to the highest individual tax rate. These withholding payments act as estimated tax payments on nonresident shareholder income and are claimed as credits by the shareholders on their nonresident individual income tax returns. Some states, like Georgia and Hawaii, waive their withholding obligations if a composite tax return is filed on behalf of the nonresident shareholders. It should be noted that other states only require withholding if the S corporation does not receive consent from a nonresident shareholder to be included in the state’s composite return.
If you have any questions regarding the multistate taxation of S corporations, please contact your Marcum representative.