When it comes to taxes, residency may have a bigger impact than you think. Taxpayers are generally acquainted with the tax withholding requirements imposed on their wage income, but are less familiar with the ways in which states impose withholding on pass-through entity income. While states typically tax their residents’ worldwide income, nonresidents may only be taxed on income or distributions earned from in-state sources. When it comes to partnerships, 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. Historically, states have had difficulty ensuring that nonresident partners properly file and pay their tax obligations. To increase compliance from such partners, many states require partnerships to either withhold taxes or make estimated payments on behalf of nonresident partners.
Approximately thirty-five states employ some variation of nonresident withholding. About half of the states impose their withholding upon allocated partnership income. Yet, for others the withholding amount is determined on actual income distributions to the nonresident partners. States also vary as to when the withholdings must be remitted. A few states require payment by the end of the first month following the close of the partnership’s tax year. Others states mandate the withholding payments be remitted together with the partnership’s tax return. Certain other states seeking to regulate tax cash-flow require quarterly withholding estimates.
Regardless of the withholding methodology and due date, taxes withheld for a nonresident partner are reflected on the partner’s Schedule K-1. For individual partners, the taxes paid to the nonresident state can usually be claimed as a credit for taxes paid to another jurisdiction on their resident state’s individual income tax return. In tiered partnership situations, withholding is performed at the operating-level. The partnership income, as well as the withholding credits, is passed up the partnership chain to each successive tier. In instances where the partnership’s in-state activity is the nonresident partner’s only connection with the state, the withholding will generally relieve the nonresident partner from any further state tax payments (though the filing of a personal tax return may be necessary).
There are, of course, a variety of circumstances that give rise to an exemption from mandatory withholding. Many states do not require withholding on distributions to corporate partners. Additionally, partnerships do not need to withhold for certain partners, including entities disregarded for federal income tax purposes, tax-exempt organizations, and publicly traded partnerships. States also often have a threshold, or de minimis amount, below which a nonresident is not subject to withholding. However, these exceptions are far from universal.
Partnerships can avoid the compliance burden of having to make periodic withholding payments by filing a composite tax return. A composite return is one tax return filed by a partnership reporting the in-state income of the partnership attributed to all eligible nonresident partners. The taxes owed are paid by the partnership on behalf of the eligible nonresident partners. To be eligible, most state rules require that the partnership be the only source of in-state income of the nonresident; the partner must not have been a resident of state at any point during the tax year; and the nonresident partner and partnership need to have the same tax year.
At first blush, the filing of a composite return appears attractive for compliance purposes, however these filings do have disadvantages. For example, composite returns tax nonresident income at the highest state marginal rates. This means that a partner may be ascribed a higher tax by participating in the composite return than if filing individually. Moreover, by not filing individually, participants cannot utilize personal exemptions, losses or itemized deductions. Another concern is the administrative burden for partnerships in determining which partners are eligible nonresidents to participate in the filing and maintaining the proper books and records supporting eligibility.
Although a uniform standard would ease burdens on both taxpayers and partnerships, currently nonresident pass-through withholding must be addressed on a state-by-state basis. If you require assistance with your nonresident pass-through withholding obligations, consulting a state and local tax professional can assist you in determining and fulfilling your state tax withholding responsibilities. If you have any questions regarding nonresident withholding taxes, please contact Alan Goldenberg, Senior Manager of State and Local Taxation and Tax Controversy, at firstname.lastname@example.org or 212-897-6421, or your Friedman LLP tax professional.