State Tax Return. Dashing Through The Snow, Passing New Pass-Through Withholding Requirements

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1 December 2008 State Tax Return Volume 15 Number 5 Dashing Through The Snow, Passing New Pass-Through Withholding Requirements Rachel A. Wilson Dennis Rimkunas Dallas New York (214) (212) Given the current economic times, it is not surprising that states are doing all they can to increase tax compliance without significantly increasing overhead. Rather than burn resources tracking nonresident partners, more states are adopting pass-through entity withholding requirements to shift the burden to pass-through entities to withhold taxes from nonresident partners. Most recently, Massachusetts and Illinois join the ranks of pass-through entity withholding states. Background Most states treat partnerships as pass-through entities; income earned by the partnership is not taxed at the partnership level, but is passed through to the partners in accordance with their distributive share. Resident partners are usually taxed in their state of residence on their entire distributive share of partnership income, regardless of where the income is earned. Nonresident partners are generally taxed by a state only with respect to their distributive share of partnership income derived from sources in that state. The majority of states now take the position that they have nexus to tax nonresident partners by virtue of the partner s ownership interest (whether limited or general) in a partnership doing business or owning property in the state. The obligation of nonresident partners to file returns and pay taxes in every state in which a partnership does business has created an administrative burden for taxing authorities as well as for partnerships and partners attempting to comply. Partners of large multistate partnerships might be obligated to file returns and pay taxes in virtually every state, even if their share of the partnership s income is minuscule. Many nonresident partners choose to ignore their filing and payment obligations, and taxing authorities have difficulty enforcing compliance of nonresident partners. Most states have responded to this problem by allowing partnerships in certain instances to file "composite" returns on behalf of nonresident partners. More recently, states have begun requiring partnerships to withhold an amount equal to a partner's share of income multiplied by the state s highest individual tax rate. In addition to Massachusetts and Illinois, states that have adopted some form of pass-through entity withholding include: California, Colorado, Georgia, Indiana, Kansas, Kentucky, Michigan, Minnesota, Missouri, Nebraska, New Jersey, New Mexico,

2 New York, North Carolina, North Dakota, Oklahoma, Oregon, Pennsylvania, South Carolina, Virginia, and Wisconsin. Massachusetts On August 8, 2008, Massachusetts Department of Revenue issued a new pass-through entity withholding regulation, 830 CMR 62B.2.2, which applies to tax years beginning on or after January 1, The regulation arose from recent legislation, which on June 1, 2008 authorized the Commissioner to require pass-through entities to withhold if he deems such action necessary for the protection of the revenue of the commonwealth. 1 The stated reason for the regulation is to improve Massachusetts personal income or corporate excise tax compliance by recipients of Massachusetts' sourced income from pass-through entities. 2 The obligation to withhold is separate from the member's or the pass through entity's obligation to file a return. General Rule Pursuant to the regulation, a pass-through entity that maintains an office or is engaged in business in Massachusetts must withhold Massachusetts personal income or corporate excise from the nonresident member's distributive share of Massachusetts-source income, unless the pass-through entity or member is exempt. 3 A nonresident is any natural person, estate, or trust that is not a resident or domiciliary of Massachusetts; any pass-through entity without a usual place of business in Massachusetts; or any corporation that does not file a tax return in Massachusetts. 4 A member includes an S corporation shareholder, a partner, a limited liability company member treated as a partner for tax purposes; and a beneficiary of an estate. 5 A pass-through entity is defined as: an entity whose income, loss, deductions and credits flow through to members for Massachusetts tax purposes, including a general partnership, limited partnership, limited liability partnership, or limited liability company with a member treated as a partner under Massachusetts tax law, an S corporation, an estate not taxed at the entity level, and a trust not taxed at the entity level, including a grantor-type trust. Exempt Pass-Through Entities A pass-through entity is not required to participate in pass-through entity withholding if it is an investment partnership; a trust required to withhold under another Massachusetts provision; or an upper-tier pass-through entity in a tiered structure where the lower tier pass-through has 1 Mass. Gen. L CMR 62B.2.2(1) CMR 62B.2.2(3)(a) CMR 62B.2.2(2) CMR 62B.2.2(2)

3 fully withheld. An investment partnership is a partnership (including LLCs treated as partnerships for tax purposes) in which: (a) substantially all of the partnership s assets consist of investment securities, deposits at banks or other financial institutions, or office equipment and office space reasonably necessary to carry on the activities of an investment partnership; (b) substantially all of the partnership s income is from interest, dividends and capital gains; AND (c) the partnership is not engaged in a trade or business in Massachusetts. 6 For the tieredstructure exemption, the upper-tier pass-through entity must demonstrate that a lower-tier passthrough entity has previously withheld and made estimated payments of all of the Massachusetts tax on Massachusetts-source income derived by the upper-tier pass-through entity that would otherwise be subject to withholding by the upper-tier entity. 7 Exempt Members In general, withholding is not required for members that are (1) exempt from federal income tax under I.R.C. 501; (2) Massachusetts residents; (3) corporations otherwise subject to Massachusetts corporate tax and that file Massachusetts returns; (4) pass-through entities that have a usual place of business in Massachusetts; (5) upper-tier pass-through entities that certify that all of their members are exempt from withholding; and (6) taxable nonresident members who establish that they are compliant with Massachusetts tax laws by (a) participating in a composite return prepared by the pass-through entity, or (b) filing a certification with the passthrough entity, stating that they agree to file tax returns, make quarterly estimated tax payments, and accept personal jurisdiction in Massachusetts state courts for the determination and collection of taxes, including estimated tax payments, and related interest, penalties, and fees imposed with respect to the income of the pass-through entity. 8 For a member to be treated as exempt, the pass-through entity must obtain annual certification by the member claiming to be exempt from withholding. Backup Withholding Notwithstanding these exemptions, a pass-through entity must withhold and make tax payments on behalf of a member if notified by the Commissioner that the resident or nonresident member has not met the member s obligation to file and pay timely. Generally, backup withholding is required for a five-year period following the Commissioner s notification. 9 Withholding Amount The annual amount to be withheld on behalf of each member subject to withholding is calculated by multiplying the withholding rate by the lesser of 80% of the member s distributive share for the taxable year, or 100% of the member s prior year distributive share. The pass CMR 62B.2.2(2), (3)(b)(1) CMR 62B.2.2(3)(b)(3) CMR 62B.2.2(3)(c) CMR 62B.2.2(3)(d)

4 through must make quarterly payments on the required annual withholding amount on behalf of each subject member for the taxable year. 10 Annual Return and Schedule If withholding is required for any member, a pass-through entity must file an annual withholding return showing the total amount withheld for the taxable year. 11 Nonexempt passthrough entities with nonresident members must file an annual schedule with its return showing the Massachusetts-source distributive share and filing method of its nonresident members. 12 Publicly traded partnerships are not required to withhold on their members, but must file the annual schedule for pass-through entities including members receiving more than $500 (the partnership is not required to report the method of compliance of its members). 13 Electronic Composite Returns Withholding is not required for flow-through members who elect to participate in composite returns. Members may elect to participate in a pass-through entity s composite return even if the member has Massachusetts-source income other than distributive share from one or more pass-through entities. In such situation, the member must file a separate return for income not covered in a composite return. Individual nonresidents may participate in more than one composite return. Composite returns for tax years beginning on or after January 1, 2009 (filed in 2010) must be filed electronically. Estimated tax payments must be made electronically through ACH Debit, beginning the first quarter of tax years beginning on or after January 1, Penalties For Failure To Withhold A pass-through entity required to withhold is jointly and severally liable with each member subject to withholding for the member's Massachusetts tax liability, including interest and penalties, with respect to its distributive share of income from the pass-through entity. Any pass-through entity required to withhold that fails to meet its withholding obligation is subject to all applicable penalties for failure to adequately withhold. 14 Credit for Tax Paid Notwithstanding the regulation, members are responsible for payment of estimated taxes on all of their income, including income from pass-through entities. Amounts previously withheld and paid to the Commissioner by the pass-through entity on behalf of a member, CMR 62B.2.2(4) CMR 62B.2.2(8)(b) CMR 62B.2.2(8)(a) CMR 62B.2.2(3)(e) CMR 62B.2.2(7)

5 applicable to the entity s taxable year ending within or with the taxpayer s tax year, may be allowed as a credit on the member s estimated tax obligation. Timing differences may result in interest and penalties being due on estimated tax payments. 15 Tiered Structures Unless exempted, each pass-through entity withholds applicable tax on behalf of its members subject to withholding, including members that are pass-through entities. To prevent multiple withholding on the same income, an upper-tier pass-through entity that recognizes distributive share income may subtract amounts withheld by a lower-tier entity from amounts required to be withheld. Upon approval of the Commissioner, a lower-tier entity may meet its withholding obligation for an upper-tier entity by directly withholding from the distributive share of members of the upper-tier entity. 16 Illinois Illinois recently enacted a pass-through entity withholding statute, effective January 11, The Illinois Department of Revenue's Pass-through Entity Payments Q&A (Nov. 18, 2008) provides some insight into why Illinois adopted the pass-through withholding requirements. In answer to why the law was passed, the Q&A states: First to insure compliance with Illinois tax laws. A large number of nonresident partners and shareholders were not filing Illinois tax returns and paying their Illinois tax liability. For the past two years, the Department of Revenue has been manually reviewing partner and shareholder information provided on Illinois income tax returns and contacting partners and shareholders who were not filing returns. This project revealed both widespread ignorance and deliberate disregard of Illinois law. To date, the department has recovered $22.5 million in unpaid tax. Second to provide a method for pass-through entities to pay tax on behalf of their nonresident owners that is more flexible and taxpayer-friendly than using composite returns. Recently Enacted Withholding Statute For each taxable year ending on or after December 31, 2008, every partnership (other than a publicly traded partnership under IRC 7704 or investment partnership), S corporation, and trust must withhold from each nonresident partner, shareholder or beneficiary (unless tax exempt under IRC 501(a) or 35 ILCS 5/205 or included on a composite return filed by the pass-through entity under 35 ILCS 5/502(f)) an amount equal to the partner, shareholder or CMR 62B.2.2(6) CMR 62B.2.2(5) ILCS 5/

6 beneficiary's distributable share of the business income of the pass-through entity apportionable to Illinois multiplied by the applicable tax rate. 18 A pass-through entity is not required to withhold tax with respect to any nonresident partner, shareholder or beneficiary (who is not an individual) from whom the entity has received a certificate of exemption stating that such nonresident partner, shareholder or beneficiary will: (A) file all returns they are required to file under 35 ILCS 5/502 and make timely payment of all Illinois taxes imposed on them with respect to income of the pass-through entity; and (B) be subject to personal jurisdiction in Illinois for income tax purposes with respect to the income of the partnership. 19 A pass-through entity must annually report the amounts withheld and from whom the amounts were withheld, and pay over the amounts withheld in quarterly estimated installments. 20 The pass-through entity is liable for the tax it withholds or is required to withhold. 21 If a passthrough entity required to withhold fails to withhold, the entity is liable for applicable penalties and interest for failure to timely withhold even if the owner subsequently pays the tax. 22 Amounts withheld and paid to the Illinois Department of Revenue are treated as payments of the estimated tax liability or of the liability for withholding of the partner, shareholder or beneficiary to whom the income is distributable for the taxable year in which liability for such income is incurred. 23 Proposed Regulations In light of the newly enacted statute, the Illinois Department of Revenue proposed new regulations to implement the withholding statute, and to amend the composite return regulations to be consistent with the new statute. The regulations are currently in the first notice period, which ends December 14, Of the proposed new and amended regulations, 86 Ill. Admin. Code is the primary pass-through entity withholding regulation. The proposed regulation provides for the treatment of overpayments and underpayments of the withholding obligation, 24 rules regarding recordkeeping and revocation of certificates of exemption, 25 and an exempt owner's remedy if the pass-through entity withholds ILCS 5/709.5(a) ILCS 5/709.5(c)(1) ILCS 5/711(a-5), 5/ ILCS 5/ ILCS 5/ ILCS 5/709.5(b) Ill. Admin. Code (e), (f) (proposed) Ill. Admin. Code (h) (proposed) Ill. Admin. Code (g)(2) (proposed)

7 Owners have no right of action against a pass-through entity for withholding tax from that owner despite being exempt under the statute; instead, the owner must file a timely claim for funding of the withholding. With respect to tiered pass-through entities, the proposed withholding regulation provides that if the owner is a pass-through entity itself, it may claim some or all of the amount withheld as a credit against the amount it is required to withhold from its owners in lieu of claiming the credit against its liability for Illinois taxes under 35 ILCS 5/ Once an owner has filed a return claiming an amount of credit against its withholding or other tax obligation, the owner may not claim that amount as a credit against any other liability. Other Guidance In addition to the proposed regulations, the Illinois Department of Revenue issued Information Bulletin FY (Oct. 2008) and Pass-through Entity Payments Q&A (Nov. 18, 2008). The Pass-through Entity Payments Q&A provides examples of how the withholding requirements apply. The Information Bulletin sets forth general instructions for complying with the requirements. Interestingly, the Information Bulletin FY states that if the passthrough entity's payments cover the nonresident owner's Illinois Individual Income Tax obligation, that owner does not need to file Form IL-1040, Individual Income Tax Return. This differs from states that require an owner to file a return even if taxes were fully withheld and paid by the pass-through entity. Differences in New Nonresident Partner Withholding Rules There are important differences between the pass-through withholding rules in Massachusetts and Illinois. For example, in Massachusetts withholding is not required for nonresident members that provide the pass-through entity with certification stating that the member agrees to file tax returns, make quarterly estimated tax payments, and accept personal jurisdiction in Massachusetts state courts for the determination and collection of taxes. 28 Illinois allows nonresident members to provide a similar certificate of exemption to pass-through entities only if the nonresident member is not an individual. 29 These differences add to the tax compliance burden of multistate partnerships. Revenue Raisers In both Massachusetts and Illinois, the pass-through withholding requirements were enacted to improve compliance and increase state revenues. It remains to be seen whether the new rules will have the desired effects on revenue. As state budgets continue to tighten, we should expect more states to add pass-through entity withholding requirements. Multistate pass Ill. Admin. Code (d)(1) CMR 62B.2.2(3)(c) ILCS 5/709.5(c)(1); 86 Ill. Admin. Code (h) (proposed). See also Illinois Dept. of Rev. General Information Letter IT GIL (Apr. 14, 2008)

8 through entities are well advised to periodically examine the applicable withholding rules in all the states in which they do business given the frequency of changes in this area of law. This article is reprinted from the State Tax Return, a Jones Day monthly newsletter reporting on recent developments in state and local tax. Requests for a subscription to the State Tax Return or permission to reproduce this publication, in whole or in part, or comments and suggestions should be sent to Teresa M. Barrett-Tipton ( ) in Jones Day s Dallas Office, 2727 N. Harwood, Dallas, Texas or StateTaxReturn@jonesday.com. Jones Day All Rights Reserved. No portion of the article may be reproduced or used without express permission. Because of its generality, the information contained herein should not be construed as legal advice on any specific facts and circumstances. The contents are intended for general information purposes only