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Top 5 Easy Ways to Identify and Comply with State Tax Filing Obligations for Pass-Through Entities

Top 5 Easy Ways to Identify and Comply with State Tax Filing Obligations for Pass-Through Entities 2

The number of pass-through entities — such as partnerships, limited liability companies taxed as partnerships, and S corporations — has been on the rise in recent decades. Today, they play a major role in the U.S. economy. These pass-through entities are not subject to a corporate income tax in most states, but many still face a considerable tax burden on their investments and profits. Staying compliant with state tax filing obligations can prove challenging.

Further, navigating the complexities of nexus and ensuring compliance can be overwhelming for any company, and pass-through entities are no exception.

Researching multistate filing obligations for multilayer business entities and ensuring nexus compliance is no small feat. Manually tracking and entering the information on spreadsheets is time-consuming and increases the risk of error, resulting in interest and penalties.

This white paper examines the ways practitioners and companies can make nexus determinations and more easily identify and comply with state filing obligations for pass-through entities, especially those operating in multiple states.

Top 5 Easy Ways to Identify and Comply with State Tax Filing Obligations for Pass-Through Entities 3

1. Know NexusIf your multistate pass-through entity client isn’t familiar with the concept of nexus, and what constitutes nexus-creating activities, the risk of non-compliance is significant.

Nexus means connection or a series of connections, and describes the amount and degree of a taxpayer’s business activity that must be present in a state before the taxpayer becomes subject to the state’s taxing jurisdiction, as explained by the AICPA1.

Nexus is highly complex, and varies from state to state and tax to tax. The requirements for sales and use tax nexus differ from corporate income tax nexus requirements, for example, and corporate income tax nexus standards aren’t the same as franchise or net worth nexus standards. To make things more complicated, states are always trying to stretch nexus to include more out-of-state sellers and a wide range of products and services. The challenges for multistate businesses have never been greater.

Let’s begin by focusing on income tax nexus. Public Law 86-272 prevents states from imposing a net income tax on an out-of-state entity if its only connection with the state is the solicitation of orders for tangible personal property, and if those orders are accepted and shipped or delivered from outside of the state2. The law applies only to taxes measured by net income, and so does not apply to sales taxes, gross receipts taxes, or most franchise taxes. It places considerable limits on a state’s ability to impose its income tax on out-of-state entities.

Therefore, it is critical that practitioners consider whether activities performed by an entity in a state exceed the safe harbors of PL 86-272. Examples of activities that can create income tax nexus (depending on the laws of the individual state) include:

• Selling services and not personal property,

• Providing services in the state,

• Accepting orders in the state,

• Delivery of property into the state on company vehicles,

• Accepting deposits in the state,

• Repossessing property in the state, or

• Having inventory in the state3

Then there’s sales and use tax nexus. In recent years, nearly half the states that imposed a sales and use tax have enacted “click-through” nexus laws, also known as “Amazon laws.” These laws require an out-of-state seller to collect taxes on sales made into the state, if the seller contracts with in-state affiliates to refer customers to the seller (through web links or otherwise) in exchange for compensation, and if those referrals generate a certain dollar amount of sales.

Many states have also enacted “affiliate nexus” laws, which require out-of-state retailers to collect tax on sales to customers in the state if the retailer has an affiliated agent who sells the same or similar products under the same or similar name.

These laws are controversial. The U.S. Supreme Court ruled in Quill Corp. v. North Dakota that a state could assert sales and use tax nexus against a company only if the company had some physical presence in the state. The physical presence could be through the company itself, or through its agents. Click-through nexus, pioneered by New York, was seen by opponents as an unconstitutional effort to stretch the meaning of “physical presence” too far. After the U.S. Supreme Court declined to hear a challenge to New York’s law4, however, click-through nexus laws spread quickly.

1 AICPA State Tax Nexus Guide, AICPA, 20142 AICPA State Tax Nexus Guide, AICPA, 20143 Income Tax Nexus and Sales Tax Nexus: Is there a Difference?, TaxJar, Feb. 20154 Overstock.com, Inc. v. New York State Dept. of Tax and Finance, 20 NY3d 586, NY Court of Appeals (2013), U.S. cert denied Dkt. No. 13-259, 12/02/2013

A growing number of states are in direct revolt against the physical-presence standard and are asserting economic nexus for sales and use tax purposes.

Top 5 Easy Ways to Identify and Comply with State Tax Filing Obligations for Pass-Through Entities 4

Now, as discussed in a recent Thomson Reuters blog post5 by Checkpoint Catalyst Senior Editor Rebecca Newton-Clarke, a growing number of states are in direct revolt against the physical-presence standard and are asserting economic nexus for sales and use tax purposes. Economic nexus holds that an out-of-state business has sufficient contacts with a state — and can be required by the state to collect tax — if the business makes a certain dollar amount or number of sales to customers in the state.

The parameters of economic nexus in the sales and use tax context vary even among states that assert it, but clarity may be forthcoming. In January 2018, the U.S. Supreme Court agreed to hear an appeal involving the constitutionality of South Dakota’s economic nexus law6.

To complicate matters further, economic nexus is actually an import from the corporate income tax environment, where other, equally complex rules and constraints govern nexus.

Given the fluidity of state tax nexus law, the range of states’ approaches and taxes, and the complexities of determining if a business has nexus, ensuring compliance can be overwhelming.

Steps to Help Simplify Nexus Compliance:• Shred the spreadsheets. If you’re manually collecting nexus-related data on spreadsheets you’re

wasting valuable time and increasing the risk of error and potential penalties

• Implement a tool that helps you easily identify reporting and filing requirements for multi-tier partnerships and S corporations doing business in multiple states

• Consider a tool that features filters to sort answers: Create Nexus, May Create Nexus, Does Not Create Nexus, or State Has No Position

• Look for a tool that has the capability to create a summary view of a state or zero in on selected activities and compare across states

• Consider a tool that enables you to view comprehensive reports by both report type and by entity, and helps you easily identify any nexus flow-up issues

• Look for a tool that quickly incorporates new developments in this uncertain and rapidly-changing area

• Be aware that tools with links to related content and source materials can further assist in your research

5 Nexus Considerations: Navigating the Kill-Quill Revolt, Thomson Reuters, Jan. 20186 State v. Wayfair Inc., 901 N.W. 2d 754 (S.D. 2017), cert. granted., U.S. S.Ct., Dkt. No. 17-494, 01/12/2018

Top 5 Easy Ways to Identify and Comply with State Tax Filing Obligations for Pass-Through Entities 5

2. Nonresident WithholdingWhen it comes to pass-through entities, it is important not to overlook the impact of residency. Why? Taxpayers are typically familiar with the tax withholding requirements imposed on their wage income, but may be less familiar with state-imposed withholding on pass-through entity income.

Many states require partnerships to either withhold taxes or make estimated payments on behalf of nonresident partners. As stated in a post7 by the firm Friedman LLP, states impose income tax upon nonresident partners based on the theory that partners in a partnership that is deriving income from the taxing jurisdiction are themselves deriving income from sources within the state. That’s why it is important for nonresident clients to understand their potential withholding obligations.

The withholding tax structure requires an entity to withhold and remit tax on behalf of the owner. In most cases, the pass-through entity will treat this as an owner distribution for accounting purposes, because it is not a deductible business expense8.

Sounds simple, right? Think again.

As explained in a post9 by the firm Horwood Marcus & Berk, some states have withholding thresholds, while the rate of withholding in other states varies depending on the type of owner. In addition, withholding may not be obligatory. For example, some states require withholding only on behalf of certain partners (i.e., individual partners), and some states only require withholding for S corporations, but not partnerships or LLCs, or vice versa.

Furthermore, while withholding may be voluntary for the pass-through entity or its owners, it may sometimes be advantageous for the pass-through entity to withhold on behalf of nonresident owners to avoid the need to pass sensitive income information to the owners for purposes of computing estimates, as the authors of the post noted. Although this approach can lead to over-withholding, it is often the simplest method when an owner’s only in-state income is the income from the pass-through entity.

On the other hand, there are some reasons why owners may not want to have the pass-through entity withheld on the owner’s behalf. For example, perhaps the owner has other activities in the state resulting in losses that could offset the pass-through entity income.

The bottom line: Withholding compliance can be more complex than it initially appears. A tax practitioner must consider the tax rules applicable to each partner in each state.

3. Composite ReturnsAs more and more pass-through entities have a presence in multiple states, states have taken a closer look at how to collect tax from pass-through members who earn income attributable to the state. Enter composite returns. To provide an alternative to withholding taxes for nonresident members, many states allow pass-through entities to file a composite return to report income and pay tax for nonresident members. Some states even require it.

While filing composite returns can reduce the compliance burden on nonresident members, it can present complexities. This is especially the case for partnerships and S corporations that have partners or shareholders in multiple states. Knowing how many composite returns need to be filed can be difficult.

“The general rule with composite returns is that the person can’t be included on a composite who is a resident of that state. The other rule is that even if they are a nonresident but they have other activities in the state then they can’t be included. So, that’s a complexity in that you have to do your due diligence internally with all of your owners and if it’s a big owner group that can be a pain,” said Raygan Evans, partner at Atlanta, Georgia-based CPA firm Bennett Thrasher.

7 Nonresident Pass-Through Withholding, Friedman LLP, Feb. 20168 State Tax Developments for Pass-Through Entities: Withholding Requirements for Non-Resident Entity Owners, Horwood Marcus & Berk, Feb. 20159 State Tax Developments for Pass-Through Entities: Withholding Requirements for Non-Resident Entity Owners, Horwood Marcus & Berk, Feb. 2015

Withholding compliance can be more complex than it initially appears.

Top 5 Easy Ways to Identify and Comply with State Tax Filing Obligations for Pass-Through Entities 6

It’s important to remember that, when it comes to composite filing, there are different challenges in different states. Some states don’t allow composite returns. Others require a minimum number of owners to participate in the composite return. Still other states may place restrictions on the types of taxpayers that can be included on the return.

Given the complexities, there are many factors that should be considered. According to the CPA firm Katz, Sapper & Miller10, these factors include:

• Does the pass-through entity qualify to file a composite return?

• Does the pass-through entity have to apply to file a composite return?

• Does the individual qualify to participate in a composite return?

• Is the tax rate that applies on the composite return higher than the tax rate that would apply if an individual return were filed?

• Does the individual have state net operating losses, suspended losses, and/or passive activity losses that they might lose by participating in the composite return?

Implementing the proper tools can help you ensure your pass-through entity clients remain compliant. For example, leveraging a tool that specializes in quick-answer charts on pass-through entities can prove beneficial.

4. Entity-Level TaxThe next issue to consider is entity-level tax. Some states assess additional taxes in the form of business privilege taxes, franchise taxes, or other excise taxes based on income, gross receipts, capital value, or net worth.

“To a large extent, there are a group of states that don’t have an individual income tax, for example, Tennessee and Texas. So, these states instead have entity-level income taxes they assess on businesses structured as pass-through entities,” said Evans of Bennett Thrasher. “Pass-through taxpayers also have to be aware of other types of entity-level taxes assessed by states that do impose an individual income tax and recognize flow-through. For example, the LLC fee imposed by California on LLCs or the net worth tax imposed by Georgia on S corps.”

Regarding gross-receipts taxes, be sure these commonly overlooked taxes are on your radar:

Ohio Commercial Activity Tax: The commercial activity tax (CAT) is an annual tax imposed on the privilege of doing business in Ohio, measured by gross receipts from business activities in Ohio11.

Washington Business and Occupation Tax: The state B&O tax is a gross receipts tax. It is measured on the value of products, gross proceeds of sale, or gross income of the business12.

Tennessee Business Tax: Generally, if you conduct business within any county and/or incorporated municipality in Tennessee, you should register for and remit business tax. Tennessee business tax consists of two separate taxes: the state business tax and the city and/or county business tax. These taxes apply to businesses with a physical location in the state, as well as out-of-state businesses performing certain activities in the state13.

“All three of those gross-receipts taxes, everyone misses. Going back to the nexus conversation, taxpayers don’t even have to have any people or channel partners or anything in those states because all three of those have a factor-based presence rule, meaning they would only have to have a certain amount of sales into those states,” said Stephen Bradshaw, director of the State and Local Tax practice at Bennett Thrasher.

10 What Nonresidents Should Consider when Filing Composite, Katz, Sapper & Miller, Feb. 201411 Commercial Activity Tax, Ohio Department of Taxation12 Business & occupation tax, Washington State Department of Revenue, 201713 Business Tax, Tennessee Department of Revenue

Top 5 Easy Ways to Identify and Comply with State Tax Filing Obligations for Pass-Through Entities 7

5. Plan AheadPlanning is obviously critical in advising current clients but it can also help accounting professionals more accurately gauge the scope and complexities of a new engagement.

“Establishing the scope is not as simple as saying, ‘you have to file in these 10 states’ because all of those states may have different numbers of returns that pertain to that specific entity,” said Evans, “So, understanding the scope, that can be tricky.”

To accurately determine how many returns would be required for a new engagement, you need to leverage tools that enable you to easily run a report on an entity’s structure.

ConclusionGiven the growth of pass-through businesses within the U.S., the dramatic increase of multistate commerce, and the evolving challenges these entities face in staying compliant with state tax filing obligations, the accounting industry is rife with opportunity.

In order to successfully serve clients, firms must bid farewell to the daunting task of manually tracking filing obligation requirements. Implementing a tool that simplifies compliance research not only saves time but helps reduce the risk of error and takes your advisory services to new heights.

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For more information, visit tr.com.

Checkpoint State Clear Complyfrom Thomson Reuters is a revolutionary tool to simplify compliance research for multi-tier business entities. You can easily identify non-resident withholding requirements, nexus flow-up issues from lower tiered entities, and ensure your multi-tier entities are in compliance — even those in multiple states.

Learn more at tax.tr.com/checkpoint/state-comply.

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