Challenging State Question

[Snaggletooth]

A realistic challenge for experienced State Tax preparers, or anyone else who wants to give it a try. I don't expect an outpouring of opinions on this one, but am eager to read what others think.

Note: Unlike the recent spate of tests by Bees Knees, I don't know the answer. There are no "hidden" considerations, or nothing intended to drag other factors.

Situation: Patrick resides in Mountain Home, Arkansas, and is 100% stockholder in "Tundra Cold Storage". Tundra is an S-corp with cold storage buildings in Arkansas and 3 other states. Every year, Tundra issues Patrick a Federal K-1, along with 4 various state versions of K-1s. The 4 states, including Arkansas, use various appointment schedules to calculate the amount of income allocable to Patrick for resident and non-resident tax reporting.

Arkansas is signatory to a "Multistate Tax Compact." The significance of this is that instead of claiming ALL corporate income as a AR resident and then taking a credit for taxes paid to other states, Patrick claims ONLY the AR apportioned income as taxable in Arkansas, but then is barred from taking the credit for taxes paid to other states. (Since AR is the state of residency, it doesn't matter whether the other states are signatory to the Tax Compact or not)

I am using very contrived numbers so as to make this as easy as I can:

Patrick invests $100,000 on Jan 1, 2006
During 2006 Tundra has $50,000 income of which $20,000 is allocable to Arkansas.
During 2007 Tundra has $100,000 income of which $30,000 is allocable to Arkansas.
During 2008 Tundra has $150,000 income of which $50,000 is allocable to Arkansas.
Over the years, Patrick has withdrawn $100,000 from the company.
Also, for simplicity, assume all the income is ordinary income.

On Jan 1, 2009, Patrick sells all of his Tundra stock for $600,000.

Question 1: What is Patrick's "Arkansas basis" in Tundra as of 01/01/09?
Question 2: What is Patrick's "Arkansas Gain" resulting from the Tundra sale?

As far as I know, there is nothing peculiar to Arkansas which would make it any different than any other state. I needed a state, and Arkansas is close...

[Roland Slugg]

Patrick's basis in "Tundra Cold Storage" on January 1, 2009 is $300,000 ... $100,000 plus 3-years' income ($50,000 + $100,000 + $150,000) less distributions of $100,000. Since Patrick is an Arkansas resident, that is also his Arkansas basis. The fact that some of the income was taxed by other states is not relevant for calculation of basis or gain on sale. The situs of Patrick's holding of Tundra shares is Arkansas, his state of residence. Thus, his gain is $300,000 ... selling price of $600,000 less basis of $300,000. The other states can tax apportioned shares of his annual Tundra income but not the gain on sale of the Tundra stock. That is taxed by the state of residence.

[Edsel]

Great Answer

The other states can tax apportioned shares of his annual Tundra income but not the gain on sale of the Tundra stock. That is taxed by the state of residence.

Actually, if this is the answer, it really makes things simple. No other fingers in the pie for disposal of Arkansas shares of stock. According to Roland, other states' claim for taxation is limited to income only, not to gains/losses.

[Davc]

Arkansas is signatory to a "Multistate Tax Compact." The significance of this is that instead of claiming ALL corporate income as a AR resident and then taking a credit for taxes paid to other states, Patrick claims ONLY the AR apportioned income as taxable in Arkansas, but then is barred from taking the credit for taxes paid to other states. (Since AR is the state of residency, it doesn't matter whether the other states are signatory to the Tax Compact or not)

I think you're not understanding this correctly. The allocation of income occurs at the Corp level. Patrick still reports all of his income to AR.

[Edsel]

Davc

Davc, I hope you are not correct. Alabama became one of the signatories to this Compact in 1998, and it was explained to me that the K-1 was designed to report only the Alabama allocation of income, and the resident shareholder would report only that income. The downside would be that the shareholder could not take the credit for taxes paid to other states. The source of the information was PriceWaterhouseCoopers (but that doesn't necessarily equate to accuracy).

I have an Alabama client in that exact situation, owning a multistate S corp with an Alabama charter. He was audited in 2004 by the State of Alabama and this was held to be correct (but of course, that doesn't necessarily equate to accuracy either).

Davc, you have been a source of much accurate information in the past, and because of your expertise I fear that I might now have been doing this return incorrectly for several years.

[Davc]

From:

Code of Alabama - Title 40: Revenue And Taxation - Section 40-18-14 - Adjusted gross income of individuals

(4) The term "gross income," in the case of a resident individual, includes income from sources within and outside Alabama, and in the case of a nonresident individual, includes only income from property owned or business transacted in Alabama.

[Davc]

Was it a individual audit or just the Corp?

[Edsel]

Individual

The individual was audited, and we got through without an adjustment. Not sure whether the auditor was tuned in to the issue or not. PriceWaterhouse prepared the K-1s. The instructions for the K-1 tell the taxpayer which lines to enter.

I don't doubt that the Alabama code remains unchanged. I think the idea of the Multistate Tax Compact was to override the various state codes on the relevant items.

Thanks for the discussion. You're a real pro, Davc.

[Davc]

Alabama is an exception to the general rule that residents are taxed on all income for S-Corp shareholders for Corps with a tax year beginning after 12/31/96!

ALABAMA DEPARTMENT OF REVENUE

ADMINISTRATIVE CODE

CHAPTER 810-3-162

Shareholder's Computation of Taxable Income

(snip)

(c) For taxpayers who are shareholders of an Alabama S corporation with a tax year which began after December 31, 1996, each shareholder shall include in gross income their deemed distributive share of the income or loss of the Alabama S corporation apportioned and allocated to Alabama. Therefore, no income from sources without Alabama is included and no credit or deduction is allowable to the shareholder or the Alabama S corporation for income taxes paid by the shareholder or the corporation to any other state, local or foreign government in connection with such income.


Fascinating......

[Edsel]

Great Research

Davc, great research. I would have never thought to look in the administrative code.

Comforting also to know I haven't messed up a client's return.