Multistate partnerships: to withhold, or not to withhold?

• Author: Van Leuven, Mary

To withhold, or not to withhold? That is the question faced by many partnerships conducting business in multiple states.

Not only might a partnership be required to withhold or make payments on behalf of partners in states where it is operating, but a few states also require a partnership to file information returns in states where any of its partners are located. The varying rules for withholding can create a compliance nightmare for multistate partnerships with a large number of partners.

For starters, the terminology used in state statutes can be confusing. For example: Does a "corporation" include an S corporation? Does a "partnership" include a limited liability company? States often use the terms "withholding" and "estimated payments" somewhat interchangeably. (For purposes of this item, "withholding" generally will mean a single, year-end payment, while "estimated tax payments" will be used when a state requires multiple payments at defined periods throughout the year, e.g., quarterly.) When researching these issues, a tax practitioner must carefully consider definitions as well as the substantive rules applicable for a given state.

Withholding requirements often vary depending on the partner's classification (e.g., individual, corporation, etc.). Almost all states provide some exemptions for certain types of partners, but these vary significantly. A tax practitioner effectively must consider the tax rules applicable to each partner in each state. Such considerations can be daunting when advising large, multistate partnerships.

Adding to the already complex compliance rules for taxpayers and practitioners, a handful of states, including Idaho, New Mexico, and Michigan, have modified their partnership withholding/estimated tax laws. This item discusses general rules as well as some of the changes that should be considered during the current filing season.

General Rules and Common Exceptions

As stated, withholding requirements often vary depending on the partner's classification (e.g., individual, corporation, etc.). The tax rate that generally applies is the highest marginal rate for the partner's entity type. Many states impose partnership withholding on nonresident individual partners. Some also require withholding for resident individuals and corporate partners. New York, for example, requires withholding for nonresident individuals and all corporations, whether or not they are domiciled or located in New York (N.Y. Tax Law...