Effects of S election on domicile should be considered in state tax planning.

• Author: Bakale, Anthony

Many practitioners have set up S corporations for Federal purposes, without considering the tax implications at the state level. By not considering all of the available options, taxpayers may be paying excessive state taxes.

Example: Company X is incorporated in California by two 50% shareholders and elects S status for Federal tax purposes. One shareholder is a California resident and the other is a New York resident. The sales office is in California and the financial office is in New York. X makes sales all over the country, using the California sales office to solicit sales by telephone.

Under Quill Corp. v. North Dakota, 504 US 298 (1992), companies soliciting sales in another state without any substantial physical presence in that state may not be taxed by that state. Therefore, X files tax returns only in California and New York. Without careful planning, undesirable state tax consequences could occur. First, in the example, the tax effects of being commercially domiciled in California versus New York should be considered. Because the company has more employees in California, it may be assumed that the commercial domicile should be in California, in which case all sales to other states where income tax returns are not filed are apportioned to California. Simply put, California "throws back" all nontaxed sales to California. For example, if 15% of sales are to California customers and 10% of sales are to New York customers, 90% of the sales must be included in the apportionment factor, because New York is the only state where other returns are required to be filed. If, however, the commercial domicile is New York, the taxpayer will be taxed by New York only on New York-source income. Because New York law does not impose a throwback rule for sales, filing returns in other states is not relevant. In essence, some sales would not be taxed anywhere. In the example, with a New York domicile, 10% of the sales would be taxed by New York, 15% of the sales by California, and the other 75% not taxed anywhere. Obviously, if New York was considered the commercial domicile, it would be highly advantageous.

In general, a corporation's commercial domicile is the place from which its business is managed or directed, rather than the place in which the business assets are located and operated. In Pacific W. Oil Corp., 289 P2d 287 (Cal. Ct. App. 1955), the court mentioned numerous factors in determining commercial domicile, such as (1) the location at...