S corporation state tax payment considerations

Feb 27, 2012
State & local tax

States tax S corporations in a variety of ways. Some recognize the federal S election and follow the federal approach of taxing the individual owners instead of the entity. Other states require their own S election, while still others do not recognize S corporations at all and tax them like C corporations. Finally, there are some states that have a combination of entity-level and owner-level taxes. As S corporations determine the states in which they have nexus and, thus, their filing requirements, the state tax payment implications should be addressed.

In an effort to improve tax collections, many states have enacted requirements that S corporations make tax payments at the entity level to cover the personal tax liabilities of their nonresident shareholders, even though the tax is not imposed at that level. In some states, the S corporation pays this tax when filing a composite return, which generally means the individual owners do not have to file separate income tax returns for that state. In other states, the S corporation makes withholding payments to the state on behalf of the nonresident shareholders, which the shareholders then claim as a payment when they file their individual income tax return for that state (similar to federal income tax being withheld on wages). As with other individual state taxes, affected shareholders may receive credit on their resident state tax return for income taxes paid to other states so that the same income is not taxed in multiple states.

At the entity level, S corporations should note that these different types of state tax payments are treated differently for federal tax purposes. If the tax is an entity-level tax (i.e., imposed on the corporation), the S corporation may deduct that expense for federal tax purposes. However, if the tax is a composite tax or withholding payment made on behalf of a shareholder, the tax should be treated as a distribution to that shareholder and not deducted as a tax expense on the S corporation's federal return. Payments of this type are made to cover a shareholder's personal expense, not a corporate expense.

While the difference between an entity-level tax and an individual tax based on the same business income may seem a trivial point, there are dangerous consequences for S corporations that incorrectly treat them. Not only do entities run the risk that the expense will be disallowed and the taxable income flowing through to the shareholders may be adjusted, but incorrect treatment of these taxes could result in the entity's S election being terminated. As an S corporation, all distributions must be pro rata among the shareholders in order to meet the single class of stock requirement, which is necessary for S corporation treatment. Since the composite and withholding payments are made on behalf of nonresident shareholders, but are not made for resident shareholders, total distributions may not end up being pro rata among all shareholders. Even if all shareholders are residents of the same state, the payments could still vary due to number of dependents, filing status and other variables.

In order for an S corporation to comply with the pro rata distribution rule, any nonresident shareholder payments treated as distributions need to be tracked carefully and trued-up to distributions made to other shareholders. In other words, the S corporation will need to increase other distributions to a level that causes total distributions (including the state tax payments made on behalf of shareholders) to be proportionate to ownership percentages.

Occasionally, S corporations have correctly treated the state tax payments made on behalf of shareholders as distributions, but failed to true-up other distributions to make them pro rata in total. If this happens, the S corporation is generally allowed to true them up within a reasonable period. The IRS has been generous in granting relief to taxpayers that file for private letter rulings, admitting the mistakes that led to the inadvertent termination of their S election. Usually, if the IRS agrees that the termination was accidental and the S corporation agrees to correct the non-pro rata distributions, the IRS will grant relief and let the entity continue as an S corporation. However, the cost of the ruling process makes this an expensive cure.

Entities operating as S corporations should carefully consider and record their state tax payments. If you have inadvertently mistreated such payments in the past, please review them with your tax advisor and consider possible corrective actions to preserve your entity's S election.

Subscribe to tax updates and insights

Choose from timely legislation and compliance alerts to monthly perspectives on the tax topics important to you.