Many law firms operate in more than one state. Oftentimes, this requires partners or shareholders to file income tax returns in states where they do not live. This can complicate tax filing requirements for each partner or shareholder and drive up the cost of their individual tax preparation costs.
The Good News
A number of states allow a pass-through entity to file what is called a composite return on behalf of its owners. A composite return is filed by the business itself and reports the owner’s share of state income. The business also pays any tax due on that return on behalf of the owner. This means is that if a composite return is filed on your behalf, you will not need to individually file an income tax return in that state. This type of return is convenient because it can reduce time, hassle, and tax preparation charges.
Are You Eligible to Participate?
Determining whether you can participate is the first step of the process. Each state’s specific requirements must be analyzed individually, as states can differ significantly.
Typical requirements to participate in composite elections include:
- You are a non-resident of that state
- You have no other income in that state
There are typically additional requirements based on factors such as the number of participants, types of participants, and whether a participant must specifically elect in or out of participation. You may elect to participate in some state composite returns and elect not to participate in others, meaning consideration can be made on a state by state basis.
Should You Participate?
Participating in allowable composite returns sounds like an easy decision at first because the owner has less paperwork to deal with and the state is satisfied from a compliance standpoint. However, there are other factors to consider:
- Will The Savings of Filing a Composite Election Outweigh The Cost?
Often times, participation in composite returns means you give up certain tax benefits, such as deductions, exemptions, and credits. Additionally, you may end up being taxed at the highest rate that particular state charges. However, this may have limited weight in the decision factor if your home state has a higher rate, or close to the same rate, as the composite return rate and your home state allows a credit for taxes paid to other states.
- Are There Other Factors I Should Consider?
There are most certainly other factors to consider besides cost. One issue to consider is the potential impact on the statute of limitations for income taxes. Typically, the statute of limitations for a state to assess tax on a taxpayer expires three years from the due date of the return or the date on which it was filed, whichever is later. However, a composite return does not start the clock if a state determines later that the owner owes additional taxes since the owner did not file its own individual return. This could be an important factor if the owner is unsure if there is other income in the state or if residency of that state could come into question.
Another important issue to consider is if there are losses passing through from the entity. Oftentimes, losses cannot be carried forward on composite returns and may, therefore, be lost. However, losses often carry forward on individual returns to be used at a future date.
Before you make a decision, ask yourself these four important questions:
- Am I eligible to participate?
- Does the tax benefit lost outweigh the tax preparation charges of the additional state return?
- Could the state argue there may be other taxes due?
- Am I receiving pass-through losses that may be lost?
The decision around which states to participate in composite elections can be a tricky one and all key issues should be weighed and considered on a state by state basis. We can help you analyze the key factors and help you select which filing method best fits your unique situation. If you have any questions, please contact Angela Chaney or one of our tax advisors at 301.231.6200.