S Corps Fake Withholding

[Snaggletooth]

It appears some states are requiring S corporations to pay personal income tax on behalf of shareholders. They call it "withholding" although actually it hasn't been "withheld" from anything.

One of these states is Pennsylvania. It requires an Alabama S Corp to pay from its own coffers an amount to Pennsylvania for all shareholders computed to have Pennsylvania income. This is true even though the shareholders have no PA wages, or worse still, even if no dividends are declared. So it can be hardly called "withholding."

I guess this is an obvious manner of collecting taxes from shareholders so PA will not have to chase them down if these shareholders don't file a return.

Another state that does this is CO, except they require the shareholders to pay instead of the corporation, and then call it a "withholding."

Do they have the right to do this?

[Uncle Sam]

S Corp Fake Withholding

NYS has been doing this for years - but provides an elect out option form (2558-E, or 2658-E-forget which).
It's a way of forcing a nonresident to file a return to obtain credit for the withholding.

[Lion]

Ct

CT does this, too.

[BOB W]

Withholding is the correct word. It is withholding from Net profit distribution.

[Burke]

NJ does it as well, and now Virginia has started to require it. But it is specifically from distributions to those shareholders who are non-residents of those states.

[ChEAr$]

I'm just not clear on how a state may do what Snaggle describes. From his post it appears that there is an Alabama corporation only with shareholders in other states. Does the
Alabama corporation have a nexus IN the state of PA? Does it do business IN that state?
Or just have one or more shareholders who are residents of that state?

If the latter, and there is no nexus, how can any corporation be subject to withholding on any payments? IRS or states do not expect withholding on dividends from GM or Ford to Georgia residents when there is a valid W9 in force.

Now I can understand Alabama demanding withholding on non residents for tax on profits.
And they do.

[Snaggletooth]

Resurrect This One

...because compadre Corduroy Frog has a similar post. Looks like I never revisited after Harlan's post. Compadre Frog may delete his post.

S corp is in the Huntsville aerospace industry and has defense/NASA contracts in several states. Of 12 states, they encounter this is in NY, VA, PA, UT, and CO in prior years.

Withholding at the highest marginal rate assures that the state will never be underpaid. Being in the position of HOLDING everyone's money means they can sit on the refund, ignore correspondence, or even pretend they never got the money. These jurisdictions often do not have an adequate reporting vehicle to assure the shareholder gets credit for the money.

Another thing that is happening more and more these days are states that are postponing refunds until they have the money. Harlan, a perfect example is your own state from the days of Fob James. AL had no money in their treasury to pay its own citizens their tax refunds, so they postponed them indefinitely. Some of my AL customers didn't get their refunds until September.

[JohnH]

NC requires state withholding on non-resident shareholders of S-corps as well. They really don't care where it comes from, as long as the corp remits the money.

It would have to be treated as a distribution, which raises an interesting question when you have both non-resident and resident shareholders. If the corp follows the rules, might these be unequal distributions which could invalidate the s-corp election unless they're somehow evened out for the resident shareholders?

[Snaggletooth]

North Carolina??

John, my client has a military contract in North Carolina, but does not withhold. If the withholding is based on "distributions" there wouldn't necessarily be any.

The withholding in the other states mentioned is based on profits (whether there are distributions or not).

[JohnH]

It is based on profits.

I was thinking about the accounting side of the payment and the overall implications for the entity & shareholders. If it is a personal expense paid by the corporation on behalf of the non-resident shareholder, then by default the payment of the "withholding" (or whatever it may be called on the state return) would be a distribution. This situation arises because the tax liability itself is a personal tax liability, not a corporate tax liability.

So making a payment for the non-resident shareholder and not making a pro-rata one for a resident shareholder would constitute unequal distributions. The solution would be to make the payment to the state on behalf of the non-resident shareholder and simultaneously writing a check for the corresponding amount to the resident shareholder, treating both payments as distributions, but I wonder how often that actually happens.

I don't have any s-corps with BOTH resident and non-resident shareholders, so the issue has never come up for me in practice, but it rolls around in the back of my head when I actually think about it. Maybe I'm looking at this incorrectly and I jumped into this discussion to get my thinking turned around if that's what's needed.

[JON]

Why is this considered new??? It has been there

if the corporation has nexus it has been done forever. The bigger question is it a "composite" or an individual shareholder payment??? If it is a composite payment the corporation is making the payment on behalve of all the stockholders and no further filing is required, if it is a witholding payment the stockholder is required to file? well if he does not file they keep the money and it is usually charged at the state's highest individual rate.

Now to States struggling with budget problems they are more agressively going after these type of operations. It is found money and even the state legislatures are giving bigger budgets to the collection process. Audits based on nexus issues go back to the 70s in my career, but the world/USA has become smaller so as to make it a bigger issue.

You still get credits for taxes paid to other states on the resident state. You are only out it the nonresident rate is higher than the resident state.

[JohnH]

In this case, nexus is irrelevant insofar as the corporation's tax return is concerned. And the lack of nexus is what makes it relevant with respect to the non-resident shareholder.

We are talking about an individual's state tax liablity which arises as a result of owning stock in an S-corp which operates in a state in which the shareholder does not live or otherwise conduct business. Since the income flows through to the individual's tax return, the "withheld" tax which has been remitted on the state tax return is not a corporate tax liablity, it is the liability of the individual. It doesn't even matter whether the individual is required to file a return in the state or whether he can choose to forego filing and just surrender the money. None of that changes the fact that it's a distribution to the non-resident shareholder.

Now in the S-corp universe as I understand it, that's a personal distribution. For example, if you and I own stock in an S-corp operating in a state in which you live but I don't, and if the corp makes a payment of my income tax liablity on my distributive share of corp profits, that's a distribution to me. The corp isn't required to make the same payment on your behalf, so now we have unequal distributions which creates the presumption of a second class of stock. Sorry, but if the corp doesn't rectify that problem, we just lost our S-corp status.

You are corrrect, this isn't new. But I'll bet there are lots of S-corps operating which have inadvertently terminated their S-corp status - they just don't know it.

Or maybe I'm wrong and someone will point out why.

[Golden Rocket]

New to Some

if the corporation has nexus it has been done forever.

Jon, it is new to some of us who do not live in aggressive tax jurisdictions. In fact, practically unheard of in most of the southern states.

But the concept is spreading and revenue-starved jurisdictions will stop at nothing. Case in point is New York, who insists on charging your first tax installment to your prior year return. This is really bizarre:

Mortimer has an $8000 tax liability for 2010 to New York, and paid in $9500. Instead of getting a $1500 refund, his 2011 first quarter liability of $2000 is added to his 2010 tax bill, meaning he now has to PAY $500 when he files his NY return.

Does he receive credit? Of course he does, but just illustrates the lengths to which a state will go to hoard money.

[joanmcq]

This really is nothing new, and the corp can elect to file a composite return on behalf of its non-resident shareholders in states in which it has nexus.

The solution is easy. Reduce the actual cash paid in distributions by the amount of withholding required. As posted earlier, taxes paid on behalf of a shareholder is part of the distribution. Just like the cash paid in wages is reduced by withholding so would an S-corp distribution.

[JON]

Nothing has changed except the auditing staffs

This really is nothing new, and the corp can elect to file a composite return on behalf of its non-resident shareholders in states in which it has nexus.

The solution is easy. Reduce the actual cash paid in distributions by the amount of withholding required. As posted earlier, taxes paid on behalf of a shareholder is part of the distribution. Just like the cash paid in wages is reduced by withholding so would an S-corp distribution.

Thanks Joan. I can remember 30 years ago going to the office (one person) of Indiana in Minnesota for an audit. Now it is found money to get your state tax revenues from people who owe it out of the state. It is becoming a bigger issue as all states have computers getting information that helps in the audit trail. Income and sales/use taxes have become a big reason that audit departments within the states are increasing in numbers even during times when state budgets are decreasing.

Each state may have some differences. There still may be some states that do not even allow S Corps. New York has always been tough. The NEXUS issue is for the corporation and the individual. My MN S Corp has nexus in PA we file S Corp there with stockholder income taxes being paid and we file the shareholders there taking credit for the taxes paid for him. The get appropriate credits back on MN and appropriate deductions on 1040 Sch A. We charge them more for return preparation. With the S corp we file in 7 states-2 composite and 5 paying in for the stockholders, plus MN.

The larger CPA firms are enjoying this as states complicate the where to file issues. A friend of mine who works for one asked me how we handle it as they have an entire tax section that deals only with state filings. I told him most of my business filings are small and the few with issues we are careful. MN has no statutue on corrections of States and taxable income to them. IF you are audited by another state, never previously filed in, that state can go back as far as they want as no statute has started because you did not file. MN says any corrections like that you get to adjust MN - so the damages are usual less unless they other tate has a lot bigger tax rate.

Eventual the feds may step in for sales tax and maybe eventually income taxes to have some simaliar rules between states. This will be a huge money maker for those who really enjoy the business, and we can all be thankful for computers.