Timing of federal deduction for PTE state tax "withholding"

[Fonsecavo]

Although mandated pass-through entity state tax payments on behalf of nonresidents are called "withholding", these payments are often made in one lump sum well after the close of the tax year.

Withholding payments reported on forms W-2 and 1099 are treated as having been made in the tax year to which they are credited regardless of when the payer actually remits the withholding to the applicable taxing authority. One consequence of this is that taxpayers are able to claim a state tax deduction on his/her federal return for taxes that were in fact paid to a state well after the close of the year.

My question is, should we treat PTE state tax withholding in the same manner, deducting on the return for the year to which it is credited regardless of the year when it was paid?

My experience has been that a K-1 often does not specify when state withholding taxes were actually paid. If the idea behind the W-2 withholding treatment is one of administrative convenience, then it may apply here as well. However, if the typical treatment of withholding has to do with the timing of when the taxpayer constructively receives the funds from which the taxes are withheld, then it may not apply.

In the case that PTE state tax "withholding" should not in fact be treated like other withholding, how safe is it to assume that the taxes were paid during the taxable year when preparing a return based on a K-1 that does not specify the year the withheld taxes were paid to the state taxing authority?

[Snaggletooth]

Timing considered ongoing all year long

I'm familiar with various states requiring "withholding" from dividends as I've had to endure several multi-state individual returns. They call it "withholding" and in its truest functional sense, perhaps it is.

I think your question is about timing of these "withholdings". I believe it is treated the same as federal withholding on a familiar W-2. In other words $20,000 could be deducted on a paycheck dated December 31, and for purposes of estimated tax, the $20,000 is treated as if it had been ratably deducted throughout the year from January forward.

I believe it is treated the same, but if not, we would have to research each state to find out. I haven't taken the time to do this.

By the way, this same ratable treatment occurs if withheld on a 1099-R. In other words, if you have a RMD, you can insist that it occur on a single payment on December 28th or thereabouts, and have massive amounts of FIT withheld. For purposes of estimated taxes, the FIT withheld is treated as if it had occurred from January forward. Great cash flow strategy.

[Fonsecavo]

Timing question with regard to federal state tax deduction, not state tax return

Your point is taken with regard to alternate "withholdings". Indeed, with K-1 nonresident withholding in the states I'm dealing with (Virginia and Maryland), it is treated the same as other withholding on the state return.

However, my question was actually with regard to the treatment of this "withholding" on the federal return. The reason I keep putting quotation marks around withholding is that although Virginia and Maryland call it withholding, it is functionally different from all other forms of withholding I have encountered. Also, I believe there are some states with similar mandated payments that don't refer to them as withholding.

With typical withholding on salaries, dividends, retirement, etc., the taxpayer actually receives a distribution in the tax year, and doesn't receive the whole thing. It doesn't matter when the state gets the payment, it's always ok to add withheld amount to the taxpayer's itemized deductions for the tax year of the cash distribution. The K-1 "withholding", on the other hand, is actually a tax assessed against the taxpayer's flow-through income from the entity for the tax year, not on cash distributions. There is no cash distribution during the tax year that "triggers" the withholding; rather, the "withholding" payment is due when the entity files its return several months after the close of the year. When the "withholding" payment is made, the entity records an equity distribution to the taxpayer on its books for the year when the payment is actually made.

On the one hand, this seems like the same situation as if the taxpayer had filed a return and sent payment at that time - in which case it would be a federal itemized deduction for the year the payment is made. On the other hand, the "withholding" payment is treated the same as other withholding on the state tax return, applied ratably over the year.

I'm not convinced the IRS would care about what the state decides to call the payment or how the state treats the payment - they would look at the facts and may well find that there is no functional difference for federal tax purposes between this "withholding" and any other payment of state tax owed that is remitted with the filing of a state tax return. On the other hand, they might decide to deem this type of "withholding" as paid during the taxable year after all. There are two reasons I can think of why this might be the proper treatment:

1) The taxpayer is considered not to have constructive receipt of the amount in question at any time during the year given that the withholding portion was understood throughout the year as having been owed to the state taxing authority and was therefore never usable by the taxpayer.

and/or

2) The real reason state income tax withholding is counted as paid during the taxable year regardless of when the entity remits the payment is that it's too much of a burden for the taxpayer to have to figure out when the entity made the actual payment, so all "withholding" payments are viewed in this light regardless of what entity remits the payment or when.

[Snaggletooth]

When to Deduct on Sch A

I now more fully understand your issue, and not sure there is an authoritative answer - at least not one with which I am familiar.

The K-1 for a subchapter S embraces the time period for a fiscal year. Most of them today are the same as calendar years but they don't necessarily have to be. With respect to anything written in code or regs, I am virtually certain there is no restriction to a calendar year.

Secondly, if there is no requirement for these state "withholdings" to be reported on the K-1, the fiscal year issue may be moot anyway. And to my knowledge, there is no such requirement to report such state withholdings from dividends on a K-1. All relevant corporations do report these withholdings to shareholders, but I believe this is only as a service and not in response to a requirement.

I believe the proper treatment for a shareholder deducting on Sch A is to deduct the withholdings that occur during the calendar year. A dividend payment in December that has been shortchanged on account of such a withholding would thus give rise to a Sch A deduction for state income taxes. It wouldn't matter that the corporation did not remit until January. The situation would be much the same as a typical payroll distributed to employees on December 30th, with no tax remittal made to the state until January 3rd. The W-2 includes the withheld state tax on 12/30, and the employee is entitled to the deduction.

The only difference is there is no W-2. The information statement is the K-1, and I'm not so sure there is a state tax reporting requirement on the federal K-1, and even if there were - the K-1 could be reflecting a fiscal rather than calendar year.

Some of the extra diligent people on this forum may know of a code/reg/pub that addresses this, but I don't. And I don't think the IRS would allow for any interpretations the states may address.