If a taxpayer invests in a pass-through entity with operations in more than one state, the investor may owe state income taxes in more states than the one in which they are a resident. For example, suppose you reside in California but are part-owner of a partnership that owns property in Arizona, Nevada, Utah, and California. In that case, you might need to file state income taxes in each state. That can be confusing, time-consuming, and complex. In many states, the entity can file a composite tax return that reports the individual state earnings of each investor.
Most businesses in the U.S. are qualified as pass-through entities. The company may be a partnership, limited liability company, S-corporation, or sole proprietorship as long as the income is reported by the owners’ tax returns, not taxed at the corporate level. In a pass-through structure, the earnings are allocated among the owners, based on their ownership percentage, and each pays taxes on their share according to their tax rate.
For example, suppose you are one of 5 partners in a company that owns real estate. If the partnership has a net income of $500,000, each partner is responsible for paying taxes on $100,000. It’s helpful to note that even if the partnership decides to reinvest the profits in additional holdings, the partners are still liable for paying taxes on the income they would have received.
Overall, pass-through entities can often enjoy tax savings compared to other structures because the company does not pay corporate taxes.
Not every state allows companies to file composite returns. For example, Nebraska, Oklahoma, Tennessee, and Utah don’t allow them, while Arizona, New York, and Vermont restrict which companies may use the method. Of course, many states like Florida and Texas have no personal income tax, so no filing is required.
A composite tax filing has the advantage of convenience for pass-through entity owners. A combined return accounts for the state tax obligations of either all owners or those who decide to participate. As an owner, you benefit from not being responsible for filing individual returns in multiple states. The paperwork reduction may also include lower tax preparation fees. However, the composite filling is not always financially beneficial for each owner, as they may either pay higher marginal tax rates or miss out on potential state deductions.
In cases where there may be a dispute about an individual owner's resident or nonresident status with respect to a particular state, that owner may cautiously decide to opt out of the composite filing. This move will allow more time for the owner to resolve any issues without facing potential penalties. Also, if any owner has other income in the individual state, they may not participate in a composite filing.
Furthermore, if the company is not profitable, it may be wiser for the owners to forgo a composite filing since prior-year losses can't be addressed using that filing method.
Overall, owners should carefully consider the pros and cons of a composite filing and reevaluate the decision yearly.