Considerations for filing composite tax returns.

• Author: Holub, Steven F.

MANY STATES AU.OW A I'ASSTHROUGH ENTITY to hic a composite return on behalf of its nonresident individual owners in lieu of each owner filing his or her own nonresident return to report and pay tax on his or her share of state income from the entity. A composite return is an individual return bled by the passthrough entity that reports the state income of all the nonresident owners or, in some cases, the electing members, as one group. Filing the composite rc-turn can also relieve the passthrough entity of the withholding requirement that many states impose on passthrough entities with nonresident owners.

It sounds like a win-win for everyone involved: The state gets its money while the owners' personal filing obligations are reduced. However, taxpayers and their advisers should consider some key issues before deciding that a composite return is the best choice. Then, even if they decide a composite return is the way to go, they must consider additional issues.

Is Composite Filing the Right Choice?

Convenience vs. Higher Taxes

One primary benefit of filing composite returns is that they are convenient for a passthrough entity's owners w ho otherwise would have to file multiple nonresident state returns. In addition, passthrough entities* owners often face a dilemma in deciding whether to file returns in nonresident states where they may not be required to file. Adding to the dilemma is that non-resident-sourced income levels may fluctuate from year to year.

Another primary benefit arises because composite returns provide the passthrough entity's owners some relief in lower rax preparation fees, since they will be filing individual!) in fewer nonresident states. State tax laws are frequent very complicated and unique to each state, and the burden of filing in many states can be substantial.

However, a passthrough entity's owner needs to consider that filing composite returns may subject that nonresident income to the highest marginal rate and not allow the taxpayer to take advantage of lower graduated rates. This consideration is especially critical in a state with a high marginal tax rate, such as California (13.3% personal income tax top bracket) or New York (8.82%), and may even be higher when local levies are considered. Furthermore, because of the alternative minimum tax, the passthrough entity's owner may not get the benefit of the full itemized deduction on his or her federal return for paying the higher state income taxes.

Filing a composite return may prevent the taxpayer from taking advantage of deductions at the applicable state level or credits that he or she otherwise may have been able to use. The passthrough entity owner's filing status also needs to be considered, as riling either jointly or married filing separately may be beneficial in a state if he or she is not included on the composite return.

Statute of Limitation

It is important to determine when the statute of limitation begins for the passthrough entity's owner in the applicable state when the composite return is filed. If it is determined several years later that a passthrough entity's owner actually had income in that state (possibly from another entity) or had spent enough time in a state to he considered a resident, the statute of limitation would not have begun to run (since no return was filed). Therefore, a passthrough entity's owner should consider not participating in the...