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Composite Returns and Nonresident Withholding for Pass-Through Entities: Navigating the Multistate Complexities

TUESDAY , MAY 1, 2018, 1:00-2:50 pm Eastern

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Composite Returns and Nonresident Withholding for Pass-Through Entities

May 1, 2018

William Brown Brown Winick (515) 242-2412 brown@brownwinick.com Jeff Weinkle, CPA State & Local Tax Manager Aprio LLP (770) 353-3071 jeff.weinkle@aprio.com

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Business Tax Preparation Landscape

• Major shift over the past 30 years in the types of

business tax returns prepared, because of:

– Federal tax reform in the 1980’s that inverted the relative corporate and individual tax rates – General Utilities repeal – “Check the box” entity classification rules – Change in Subchapter S eligibility rules – Emergence of limited liability companies in 1990’s – Growth of robust computer tax preparation software and ability to easily prepare multistate returns with numerous

• wners

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What are the stakes?

• Audit adjustments on entity returns affect tax

liabilities of owners

• Impact on tax preparers
• Effect of new partnership audit rules
• States hungering for more tax dollars, particularly

from out of state businesses

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Constraints on State Taxation of Multistate Businesses

• Due Process Clause of the 14th Amendment

– Source of apportionment requirements

• Commerce Clause of U.S. Constitution

– “Dormant” commerce clause

• P.L. 86-272

– Applies to sales of goods only – Not as broad an exemption as commonly viewed

7

Case History

• National Bellas Hess, Inc. v. Department of Revenue

385 U.S. 753 (1967)

• Complete Auto Transit, Inc. v. Brady 430 U.S. 274

(1977)

• Moorman Mfg. Co. v. Bair (1978)
• Quill Corp. v. North Dakota 504 U.S. 298 (1992)
• Wisconsin Department of Revenue v. William Wrigley,
• Jr. (1992)

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State of South Dakota v. Wayfair

• Response to dicta from justices in U.S. Supreme

Court regarding Quill decision

• 2016 South Dakota statute
• Declaratory judgment action by state
• Summary judgment motion by Wayfair
• State appeal to South Dakota Supreme Court
• Certiorari to U.S. Supreme Court granted; case

argued on April 17, 2018

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Why Wayfair?

• Justice Kennedy dicta in Direct Marketing

Association v. Brohl (2015)

• Justice Thomas dicta in Comptroller v. Wynne

(2015)

• Judge Gorsuch dicta in 10th Circuit decision in

Direct Marketing Association v. Brohl (2016)

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Nexus

• Physical presence – National Bellas Hess; Quill
• Agency nexus – Scripto, Tyler Pipe
• Affiliate nexus – SFA Folio Connections; Borders

Online

• Click through nexus – Amazon
• Economic nexus – MBNA; Capital One
• Licensing nexus – Geoffrey; KFC

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Allocation and Apportionment

• Allocation – principally regarding real estate

income, personal services income or investment income of residents

• Apportionment – all other types of income

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Apportionment

• Three factor – sales, property, payroll
• Single factor – sales only
• Modified three factor – double weighting of

sales

• Special apportionment approaches for specific

businesses, particularly transportation and utility businesses

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Methods of Enforcement

• Alternative taxes

– Franchise taxes – Gross receipts taxes

• Nonrecognition of pass-through status; required

C corporation treatment

• Withholding requirements
• Loss of qualification to do business in state and to

access court system

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Withholding

• Income base for withholding

– Pass through income – Distributions

• Withholding rate
• Alternatives to withholding

– Submission to jurisdiction of state and agreement to file nonresident return – Composite state filing by business on behalf of nonresident owners – Estimated tax payment requirements

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Nonresident Withholding

• 33 states require withholding on certain nonresident partners
• Applicability & rates depend on type of owner
• How do states define “nonresident” for individual persons and

business entities?

• Basis of Tax:

– Distributive share of apportioned/allocated state income – Actual distributions

• Owner files state return to claim payments against tax/obtain

refunds

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Withholding Exemptions/Opt-Out

• Rules may vary between partnerships and S-corporations
• Possible exemptions:

– De minimis threshold – Exemption Forms or Affidavits: owner consents to state taxation – Participation in Composite/Group tax return – Exempt entities, investment/publicly traded partnerships, etc.

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Common Withholding Problems

• Withholding may not be reflective of ultimate tax liability

– Issues with multi-tiered entities – Net Operating Losses

• Owner may have to make separate estimated tax payments if

withheld amount is insufficient to cover liability

• As partnership enters new states, distribution/guaranteed

payment agreements with owners may need to be modified

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Composite Returns

• Single group return filing on behalf of nonresident owners
• Eliminates need for owner to file separate state return
• Administrative convenience vs. lower tax liability
• Calculation of tax:

– Typically computed by multiplying owner’s share of income apportioned/allocated to state by the highest marginal tax rate – Some states provide alternative calculation options

• Which entities can file?

– State approval may be required – Minimum number of participants may be required

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Composite Returns

• Which owners can participate? Typical requirements may

include:

– Nonresident for entire tax – Does not maintain permanent place of abode in state – The owner’s only source of state income comes from this pass-through entity (or other PTEs where composite returns are filed) – Same tax year as PTE or other owners

• What about disregarded entities?

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Mechanics - Required Information from Owners

• Entity type – how is the owner taxed?
• Is the owner a resident/nonresident of each state?
• Does the owner have a withholding exemption?
• Is the owner eligible to participate in the composite return?
• If eligible, does the owner choose to participate in the

composite return?

• Has partnership/S-corporation collected the appropriate

forms/affidavits?

• Annual election memo to owners strongly recommended

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Example: Owner Memo Language

Georgia requires partnerships to withhold state income taxes on its nonresident members’ distributable shares of income unless the member participates in the composite tax return or files a withholding exemption affidavit (see attached Form NRW-Exemption). Members who do not participate in the composite return may be required to file a separate Georgia tax return.

• 1.

Are you a resident of Georgia during 2017? Yes _____ No _____

• 2a.

If you are a nonresident, are you eligible to participate in the composite tax return filing? Yes _____ No _____

• 2b.

If eligible, will you participate in the composite tax return filing? Yes _____ No _____

• 2c.

If participating in the Georgia composite return, do you have any other sources of taxable Georgia income? Yes _____ No _____

• 2d.

If participating in the Georgia composite return, please indicate your federal tax filing status and number of dependents: _____ Single _____ Married filing jointly _____ Married filing separately _____ Number of dependents

• 3.

If you are a nonresident who is not electing to participate in the composite return, have you requested a withholding exemption by completing Form NRW-Exemption? Yes _____ No _____ 27

Challenges for Pass-through Entities

• Record keeping

– Owners’ elections – Calculating estimates and preparing returns

• Estimated payments

– May need separate payments if withholding for some partners and filing composite for others

• Coordinating scheduled distributions with state

estimate/return payment requirements

• Mitigating risk

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Mechanics - Withholding

• Election Timing

– When should elections be collected from owners? – Duration of elections: annual, biannual, or perpetual – CA waiver request requires state approval

• Estimated Payments
• Information Reporting to State
• Inclusion of elections with partnership/S-corporation tax

return

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Mechanics - Composite Filing

• Entity election - may need approval prior to filing
• Partner elections – generally binding for the tax year

– When can owners still file separate state returns?

• Some states require elections or consent forms from owners,

tax power of attorney

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Issues Concerning Sales of Partnership Interest

• How is gain taxed for state purposes?
• Withholding/composite considerations for multi-tiered

partnerships

• Special rules regarding specific allocation vs. apportionment of

gain

• Potential issues when partnership holds real estate
• Common mistake – distributing entire proceeds before state

tax considerations examined/paid

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Issues Unique to S-corporations

• Distributions must be equitable
• How to approach states that do not conform to federal S-

election:

– Potential opportunities – Consider tax rates, taxes paid deductions/credits, costs of compliance

• Multiple instances of income, capital/net worth, and/or

minimum taxes

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Issues Unique to S-corporations

• Limitations on resident state credits for taxes paid to other

states

– Criticare Inc and Marina Shakour Haber v. Director, NJ Tax Court Docket

• No. 008253-2013
• Sales of S-Corporation stock

– Historically treated as intangible but some states may have special rules – NY Advisory Opinion TSB-A-15(5)I

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Election/Planning Strategies

• Owners must evaluate their own tax situation

– Composite tax at highest marginal rates vs. graduated rates – Forego standard deductions, personal exemptions

• Re-evaluate for 2018 due to tax reform changes
• States that do not follow pass-through treatment

– Owners may still benefit from tax paid by entity in certain states – Planning in states that require separate S-elections and QSSS elections – H. Alan Rosenberg v. Commissioner, GA Tax Tribunal No. 1414626

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Election/Planning Strategies

• Loss years

– States may not allow carryforwards on composite returns, no carryback

• ption
• Statute of Limitations risks for owners

– Nexus/sourcing issues on other sources of income – Residency/domicile issues

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Composite Returns and Nonresident Withholding for Pass-Through Entities

Questions?

William Brown Brown Winick (515) 242-2412 brown@brownwinick.com Jeff Weinkle, CPA State & Local Tax Manager Aprio LLP (770) 353-3071 jeff.weinkle@aprio.com

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