State tax considerations of passthrough entities: potential concerns and pitfalls.

• Author: Nakamura, Karen

TIME AND AGAIN WE HEAR HOW SMALL businesses drive the U.S. economy. According to a 2009 report by the Small Business Administration Office of Advocacy, (1) small businesses create most of the nation's new jobs, employ about half of its private sector workforce, and provide half of its nonfarm, private real gross domestic product.

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Despite their strong contribution to the nation's economy, small businesses face significant challenges in the current economic climate in a number of areas, not the least of which is the ability to access capital in a difficult financial market. In addition, small businesses face difficulties obtaining affordable health insurance and hiring and retaining a qualified workforce. Small businesses also cite taxes and regulatory policies as significant challenges to their success.

The issues of taxes and regulation--from a state perspective--may often be overlooked in structuring small businesses, many of which are organized as passthrough entities, such as partnerships, limited liability companies (LLCs), and S corporations. (2) State taxation of passthrough entities and their owners varies widely, with rules often dependent upon the type of entity involved and differing markedly from state to state and from a federal perspective. As a result, entities and their owners may face substantially different tax consequences based on their organizational structure, business operations, types of income, tax elections, and states in which they operate. In addition, state rules that impose compliance obligations on passthrough entities and their owners, even where a connection with a state may be limited, lead to burdensome reporting requirements that may trip up even the most well-intentioned business owners and advisers.

The move by a number of states toward mandatory withholding or estimated tax payment requirements by passthrough entities further complicates an already challenging tax regime. The adoption of hybrid tax structures such as those adopted in Ohio with the commercial activities tax, Michigan with the business tax, and Texas with the margin tax expand the reach of state tax laws to entities previously not subject to entity-level taxes. Given the potential of significant penalties as a result of the failure to comply with tax reporting obligations, business owners and their advisers should become familiar with the state and local laws, regulations, and policies that apply to passthrough entities. The above concerns are important considerations whether a passthrough entity is currently doing business outside its home state or is seeking to expand its geographic footprint.

This column highlights areas of concern regarding the taxation of passthrough entities, including entity classification, conformity to federal tax conduit treatment, and tax reporting obligations. Because this item does not provide guidance on specific state rules, passthrough entity owners and their advisers are directed to seek out clear and specific guidance regarding the taxation of passthrough entities in the states of concern.

Entity Classification

Determining state conformity to the federal entity classification is an important first step in understanding the potential state tax aspects of passthrough entities and their owners. In general, states automatically conform to the federal entity classification of partnerships, S corporations, LLCs, and limited liability partnerships (LLPs); however, there are differences.

For example, Arkansas follows the federal S corporation election, but that election and shareholder consents must be filed with the Arkansas director of the Department of Finance and Administration in the same manner and at the same time as required for federal tax purposes for the election to apply for state tax purposes. (3) If a corporation fails to make a state election as required by law, it will be treated as a C corporation. In addition, failure on the part of nonresident shareholders to timely file Arkansas personal income tax returns reporting tax due on their distributive share of income will result in revocation of the S corporation election.

Georgia conforms to the federal S corporation election only if all stockholders are subject to tax in Georgia on their portion of corporate income or if all nonresident stockholders pay Georgia income tax on their portion of corporate income. (4) New Jersey requires that a state-specific election (Form CBT-2553, New Jersey S Corporation or New Jersey QSSS Election) be filed with the Division of Taxation within one calendar month of the allowable federal S corporation election date. (5) New York has a similar state-specific S corporation election requirement. That election, made by timely filing Form CT-6, Election by a Federal S Corporation to Be Treated as a New York S Corporation, is valid only if:

* The corporation is a federal S corporation;

* It is subject to tax under Article 9-A or Article 32 of the tax law; and

* All the corporation's shareholders consent to the New York S election. (6)

Pennsylvania allows a federally electing S corporation to opt out of state S corporation treatment provided 100% of the corporation's shares consent on the day the election is made. (7) Tennessee does not adopt the federal S corporation provisions and requires S corporations doing business in the state to file excise tax returns and pay tax as if an S corporation election had not been made at the federal level. (8) Corporations that have already elected S corporation status for federal and other state purposes that expand into new states should determine if and when additional, state-specific elections are required to avoid missed election deadlines.

Federal income tax provisions dealing with LLCs under the federal...