Thinking above and below the line for S corporation composite taxes.

• Author: Packard, Pamela

A majority of states have recently adopted provisions that allow composite return filings by S corporations. Such filings ease shareholders' burdens by allowing the S corporation to file returns and make state tax payments on behalf of its nonresident shareholders. As "group filings" are a relatively new concept, there is little guidance on how such payments should properly be treated for Federal tax purposes.

Ordinarily, individuals are not entitled to "above the line" deductions for state income taxes paid on business profits (Rev. Rul. 70-40). On this basis, one might argue that the payment of the taxes by the corporation should result in deemed distributions to the shareholders, who could deduct the taxes as itemized deductions on their individual tax returns. However, if the individuals do not itemize deductions (or if their itemized deductions are limited), they may lose the benefit of all or part of the state tax deduction.

Alternatively, taxes paid by an S corporation in a group filing can be easily differentiated from an individual's state income taxes, in that the payments being made by the corporation are specifically authorized by state statutes. On this basis and on the basis of Sec. 164(e) and Regs. Sec. 1.164-7, it could be argued that such payments are deductible by the S corporation and are not deemed distributions to the shareholders. Under this scenario, the net result would be an above-the-line deduction to each shareholder for his proportionate share of the state composite taxes paid. Additionally, this deduction would not be treated as a tax preference item to the individual shareholders for alternative minimum tax purposes.

Sec. 164(e) states:

Where a corporation pays a tax imposed on a shareholder on his interest as a shareholder, and where the shareholder does not reimburse the corporation, then the deduction allowed by subsection (a) shall be allowed to the corporation; and no deduction shall be allowed to the shareholder for such tax.

This section is applicable to S corporations under Sec. 1371(a), which states that for tax purposes, unless otherwise provided, an S corporation is treated the same as a C corporation. Because the deduction is not allowed to the shareholder, it is not an item that could affect the tax liability of any shareholder (as described in Sec. 1366(a)(1)(A)). Consequently, the deduction is taken into account in determining the S...