Pass-through entities may file composite tax returns in most states with a state-level individual income tax. The owners that are eligible to be included in a composite are those who are residents of other states. For example, suppose you reside in Michigan but are a partner in a company that owns property in California, New York, Utah, and Florida. In that case, your company may want to file a composite return for the states where you are not a resident.
Keep in mind that since Florida has no state income tax, the company won’t need to file there. Also, Utah does not allow the filing of composite returns, and New York has restrictions. However, the company could file for California and possibly New York in this example.
Who completes the return?
The company can decide whether to file a composite (also called a group nonresident) return. The company must distribute Schedule K-1 forms to all owners. Each owner can choose whether to participate or not. To qualify for inclusion in the composite return, the owner must have no other income in the state for which the return is prepared. Choosing a group nonresident return can be a good approach for some companies with operations in multiple states. Each owner may save time and money and reduce the number of filings for which they are obligated.
Advantages and disadvantages of a composite return.
Convenience and reduced tax preparation fees are among the primary benefits to owners participating in a group nonresident tax filing. Each pass-through entity that files a composite return must provide the choice of inclusion to each owner.
Some potential pitfalls of participating in the filing of a composite return are:
- Paying a higher than necessary tax rate. The income reported on a composite return is taxed at the highest marginal individual rate, potentially precluding the taxpayer from the benefit of lower graduated rates.
- Potentially missing out on available deductions.
- Overpaying in case of a prior-year loss.
Be careful to equalize disparate distributions and provide information promptly.
Many pass-through companies have operating agreements that disallow disproportionate distributions to a subset of owners. For example, suppose the company files composite returns in one or more states, but not all owners elect to participate in the group nonresident filing. In that case, the state income tax payment may inadvertently trigger disproportionate distributions to those who chose to participate. If the company pays state income tax obligations for some but not all owners, it will need to equalize the payments with cash distributions to the non-participating owners.
The pass-through company should communicate to the owners (and their tax advisors) about planned composite tax filings, offering adequate time for the owners to decide whether to join the composite filing. This practice is appropriate out of consideration to the owners, but also, the owners' individual decisions can affect the entity. This circumstance matters because some states require a particular percentage of owners to opt in for a composite filing to be allowed.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Programs that depend on tenants for their revenue may suffer adverse consequences because of any financial difficulties, bankruptcy or insolvency of their tenants.
Hypothetical examples shown are for illustrative purposes only.