2022 State Elections Toolkit
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Key Takeaways:

  • Many states allow or require partnerships to file composite tax returns, simplifying the tax filing burden for nonresident individuals who are members of a partnership doing business in a state. However, where the nonresident partnership interest is owned by a corporation which itself is filing a tax return in the state, the composite return concept creates undue burdens.
  • In such an instance, both the corporation and the partnership may make tax payments on the same income. Recognizing this problem, many states have eliminated the withholding requirement on nonresident corporate partners who meet specified criteria.
  • States still requiring withholding for nonresident corporate partners should eliminate the requirement. This change would ease compliance and filing burdens for taxpayers and administrative challenges for the state, and the state would have a more accurate picture of true corporate tax liability and state revenues.

The Problem: Treating Taxable Corporations as “Nonresident Partners”

Many states allow or require partnerships to file composite tax returns, simplifying the tax filing burden for nonresident individuals who are members of a partnership doing business in a state.

However, where the nonresident partnership interest is owned by a corporation which itself is filing a tax return in the state (the partnership interest “flows up” to a corporation), the composite return concept creates undue burdens. In such an instance, both the corporation and the partnership may make tax payments on the same income. While the corporate partner may be able to adjust its estimated taxes, often the corporate partner cannot fully adjust for the amounts withheld by the partnership (e.g., instances when a corporate partner has tax attributes such as losses or credits from prior years that offset tax in the current year, known as "carryforwards").

Thus, it is almost inevitable that corporations who own an interest in a partnership and who are already filing tax returns in a state will significantly overpay tax on the partnership income. Although the corporate partner can seek a refund for the overpaid tax, requiring withholding by the partnership for corporate partners is an unnecessary administrative burden on both the taxpayer and the state.

Solution: States Should Eliminate the Withholding Requirement on Nonresident Corporate Partners

Recognizing this problem, many states have eliminated the withholding requirement on nonresident corporate partners who meet specified criteria. These criteria include: the filing of a request for a waiver or a consent to pay tax; the filing of a tax return in the prior year by the corporate partner; or the signing of a tax agreement. Nearly half of the states that impose an income tax have already solved this problem by implementing filing exemptions for corporate partners (19 states shown in blue on the map below).

States still requiring withholding for nonresident corporate partners (including Hawaii, Indiana, New Jersey and Virginia) should eliminate the requirement. Alternatively, these states could allow for a filing of an affidavit, waiver request, or other process recognizing that the nonresident corporate partner will file a return either separately or as part of a combined group. 

Under any of these alternatives the corporate partner would continue to pay estimated taxes on its income and, as a result, there would be no fiscal impact to the state. The elimination of the withholding requirement would ease compliance and filing burdens for taxpayers and administrative challenges for the state. By eliminating overwithholding combined with the filing of refund claims for overwithholding, the state would have a more accurate picture of true corporate tax liability and state revenues.

The elimination of the withholding requirement would not impact the ultimate tax liability of the business nor would it jeopardize the underlying policy goal of the withholding provisions. Taxes attributable to corporate nonresident partners would be accounted for through existing state estimated tax requirements.

Background

In 2003, the Multistate Tax Commission (MTC) adopted model legislation establishing a withholding requirement for pass-through entities that have nonresident partners and allows for a composite return that can be filed by the pass-through entity on behalf of the nonresident partners.

MTC initiated the project based on a request by a taxpayer seeking a simpler way of reporting state income taxes to multiple states for multiple nonresident partners of pass-through entities. In developing the model bill, members of the MTC Uniformity Committee also expressed concerns about whether nonresident partners are properly reporting taxes owed, if any, to a state. 

The MTC model eliminates the requirement to withhold on nonresident partners if a composite return is filed. This simplifies the burden for nonresident individual partners. The MTC model contains optional language that would limit the proposal to individual nonresident partners. For states adopting the optional language, there is no problem to be solved for nonresident corporate partners. If the MTC model is reviewed for potential revisions, consideration should be given to making the current “optional” language the default, as it is the preferred policy solution.