States have a wide range of rules regarding how a nonresident shareholder/member/partner must report their share of state-sourced income. Most states either require or offer an election to the pass-through entity to file a composite return on the nonresident’s behalf. A composite return is a return filed by the pass-through entity that reports the nonresident owner’s share of state income, and calculates tax that is paid by the pass-through entity on behalf of the nonresident owner. Often, a composite return filed by the entity will eliminate the need for the nonresident to file an individual income tax return with that state. In the states that offer an election to participate in the composite return, nonresident owners must evaluate the consequences of an election and determine the impact on their overall tax liability and filing requirements.
Many factors should be considered by a nonresident owner when faced with the decision to opt in or opt out of a composite return, including:
- Does the pass-through entity qualify to file a composite return? For example, in New York and Arizona, the entity must have a certain number of participating nonresident owners to be allowed to file a composite return.
- Does the pass-through entity have to apply to file a composite return? If so, when does such application have to be completed?
- Does the individual qualify to participate in a composite return? In some states, an individual may not participate in a composite return if the individual has multiple sources of income in that state. For instance, if an individual receives multiple state K-1s or the individual receives a state K-1 but also has direct rental income in a state, s/he may be prohibited from participating in the composite return filed by the pass-through entity.
- Is a composite election binding? If the individual agrees to be in a composite return this year, is that binding to all future years, or can the election to file composite be made annually?
- What does the individual give up by participating in the composite return? In exchange for the ease of filing as a composite participant, many states require the individual to give up certain benefits they would otherwise receive if they filed an individual return. Generally, benefits of a standard deduction, state exemptions and some state credits are only available to those who file an individual return and are not available at the composite level.
- Similarly, 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?
- Is the tax rate applied on the composite return higher than the tax rate applicable if an individual return was filed? States that have a graduated tax rate for individuals often require the state-sourced income at the composite level to be taxed at the highest individual tax rate regardless of the amount of state-sourced income. For example, Kentucky composite tax is paid at the highest marginal tax rate for individuals.
- Can the individual still file a return even if they have participated in a composite return? This process could allow a nonresident to recapture some of the rate differential that was discussed above.
- If an individual return is allowed or required in addition to participation in the composite return, how is income calculated on the individual’s return, and does the individual get to take credit for any composite tax paid by the entity on his behalf? For example, assume an individual has several sources of Massachusetts income and the individual is included in a Massachusetts composite return for one of the entities that issues him a Massachusetts K-1. However, the individual does not participate in any other composite filings related to his other Massachusetts income. He will still be required to file an individual return in Massachusetts to pay the tax on the remaining Massachusetts source income. When he files his Massachusetts return, he will only include his Massachusetts income that has not be accounted for or taxed as part of a composite return. In addition, he does not pick up the composite tax paid by the entity as a payment on the individual return. That may trigger an adverse situation that the taxpayer was not anticipating.
- What is the complexity of the return filing process for completing a composite return versus individual return? And vice versa: What are the different forms and tax accounts that need to be set up with the state to receive composite payments, etc.?
The above is not an all-inclusive list of things to consider in determining whether a nonresident wants to opt in or opt out of a composite filing. This is merely a sampling of the things to be considered when making such a decision. Pros and cons need to be weighed in each situation. Please contact your KSM advisor to help you weigh the decision.
Donna Niesen is a partner in Katz, Sapper & Miller’s State and Local Tax Practice. Donna provides a wide variety of tax consulting services in the areas of multistate sales and income taxes, business incentives, controversy services, and other state taxes.
Alyson Lurker is a manager in Katz, Sapper & Miller’s Tax Department. Alyson provides services in tax compliance and consulting to a diverse clientele on technical tax matters. Her primary responsibilities include technical review of federal and state tax issues.