7.5 State and Local Tax Issues for Business Entities

Module Overview

State and local taxes (SALT) are a critical consideration for businesses operating in the United States. These taxes, imposed by individual states and local jurisdictions, can significantly affect the after-tax profitability of an enterprise, influence business structure decisions, and impact compliance costs.

State and local tax regimes differ widely in their approaches to taxing business entities. These variations stem from differences in entity-level versus owner-level taxation, apportionment methods, nexus standards, and unique local or state-specific requirements. This module delve into major aspects of state and local taxation as they apply to C corporations, S corporations, and partnerships, highlighting practical issues, compliance challenges, and planning considerations.

State Taxation by Entity Types

Business entities are generally classified for state and local tax purposes as C corporations, S corporations, or partnerships. Each classification carries distinct tax consequences at both the entity and owner levels. Understanding these distinctions is the foundation for effective SALT planning.

• C Corporations: Typically subject to entity-level income or franchise taxes in most states.
• S Corporations: Treated as pass-through entities for federal purposes, but state treatment varies; some impose entity-level taxes or do not recognize S status.
• Partnerships: Generally not subject to entity-level tax; income flows through to partners, who report it on their own returns.

The interplay between entity-level and owner-level taxation, as well as differences in apportionment, nexus, and compliance obligations, creates a complex landscape that demands careful navigation.

C Corporations: Entity-Level Taxation, Nexus, Apportionment, and Double Taxation Risks Entity-Level Taxation

C corporations are subject to tax at the entity level in nearly all states. Most states impose a corporate income tax, franchise tax, or both, calculated based on federal taxable income as a starting point, with state-specific modifications. These may include addbacks or subtractions for items such as state taxes, interest, or depreciation, resulting in a state-specific tax base.

Some states levy alternative or additional taxes, such as gross receipts taxes or minimum fees, which may apply regardless of profitability. For example, Ohio and Washington impose gross receipts taxes (the Commercial Activity Tax and the Business & Occupation Tax, respectively), while California imposes a minimum franchise tax on corporations.

Nexus Standards: Economic Nexus and Physical Presence

A state’s authority to tax a corporation depends on whether the entity has “nexus” with the state. Traditionally, nexus was established by physical presence—such as owning property, employing personnel, or maintaining inventory in the state. However, many states now assert economic nexus, taxing out-of-state businesses based on the amount of sales or economic activity, even without a physical footprint.

For example, a state may require an out-of-state corporation to file and pay taxes if its sales into the state exceed a specified threshold (e.g., $500,000). These economic nexus standards have expanded the reach of state taxation, particularly in the wake of landmark cases such as South Dakota v. Wayfair, Inc., which upheld economic nexus for sales tax purposes and influenced income tax nexus as well.

Public Law 86-272 Protections

Public Law 86-272 provides a federal shield against state income taxation for certain out-of-state sellers of tangible personal property. Under this law, a state cannot impose net income tax on a business if its only activity in the state is soliciting orders for sales of tangible goods, with orders approved and shipped from outside the state. This protection, however, does not extend to sales of services, intangible property, or gross receipts taxes, nor does it apply to activities beyond “solicitation.”

States have increasingly interpreted the limits of “solicitation” narrowly, and recent guidance from the Multistate Tax Commission (MTC) further restricts the scope of PL 86-272, particularly regarding internet-based activities.

Apportionment Methods and Nonconformity with Federal Tax Rules

Corporations operating in multiple states must allocate (apportion) their income among the states in which they do business. Most states use apportionment formulas based on factors such as sales, property, and payroll. The trend has been toward single sales factor apportionment, where only sales within the state relative to total sales determine the share of income taxable by that state.

Nonconformity arises because states often depart from federal definitions or rules in calculating taxable income. For example, states may decouple from federal bonus depreciation or interest expense limitations, requiring separate calculations and adjustments. This nonconformity increases compliance burdens and the risk of inconsistent tax treatment.

Throwback Provisions and Multi-State Double Taxation Risks

Some states apply “throwback” rules, requiring sales of tangible personal property that are not taxable in any state to be “thrown back” to the origin state and included in its sales factor. This can lead to double taxation, as the same income may be taxed by more than one state.

Double taxation can also occur when states use different apportionment formulas or sourcing rules, or when credits for taxes paid to other states are unavailable or limited. Careful planning and documentation are required to manage these risks.

S Corporations: Federal vs. State Treatment, PTE Elections, Nonresident Compliance Federal Pass-Through Treatment vs. State Taxation

While S corporations are generally treated as pass-through entities at the federal level (with income, losses, deductions, and credits flowing through to shareholders), state treatment varies widely:

• Some states fully conform to federal S corporation rules, taxing income only at the shareholder level.
• Others impose entity-level taxes on S corporations, such as franchise taxes, gross receipts taxes, or minimum fees.
• Certain states do not recognize the S election at all, treating the entity as a C corporation for state purposes.

This divergence requires S corporations to analyze the rules in each state where they do business and may result in the need to file corporate and shareholder returns.

Elective Pass-Through Entity (PTE) Taxes and SALT Deduction Limitations

The federal Tax Cuts and Jobs Act (TCJA) of 2017 imposed a $10,000 cap on the deduction for state and local taxes (SALT) for individuals, including income taxes paid through pass-through entities. In response, many states enacted elective PTE-level taxes. Under these regimes, S corporations can elect to pay state income tax at the entity level, allowing the entity to deduct state taxes for federal purposes (since the cap does not apply to business entities), with shareholders typically receiving a state credit or income exclusion.

The specific mechanics of PTE elections, including eligibility, timing, and credit mechanisms, vary significantly by state.

As of recent years, a majority of states have enacted elective Pass-Through Entity (PTE) tax regimes in response to the federal SALT deduction limitation. States allowing PTE elections include California, New York, New Jersey, Illinois, Connecticut, Massachusetts, Georgia, Minnesota, Ohio, Oregon, Colorado, and many others. However, the availability, mechanics, and benefits of PTE elections vary significantly by state.

It is important to note that while most states with an income tax now offer some form of PTE election, not all do. States like New Hampshire and Tennessee, for example, do not currently allow such elections for pass-through entities. For the most current and comprehensive list, consult each state’s department of revenue or recent legislative updates.

Nonresident Shareholder Compliance: Withholding and Composite Filings

S corporations with nonresident shareholders face additional compliance obligations:

• Withholding Requirements: Many states require S corporations to withhold state income tax on the distributive shares of nonresident shareholders, ensuring tax collection even when the owner does not file a state return.
• Composite Returns: Some states allow or require S corporations to file composite returns on behalf of nonresident shareholders, reporting and remitting state tax collectively. This can simplify compliance but may impose higher effective tax rates or limit deductions/credits.
• Nonresident Filing: In states without composite filing or withholding, nonresident shareholders are typically required to file individual state income tax returns.

These rules are designed to facilitate tax compliance and collection, but they add complexity for S corporations operating in multiple states.

Partnerships: Pass-Through Taxation, Withholding, Composite Filings, Tiered Structures Pass-Through Taxation and State Treatment

Partnerships, including limited liability companies (LLCs) taxed as partnerships, are generally not subject to state entity-level income tax. Instead, income, losses, deductions, and credits are passed through to partners, who report their share on their own returns—individual, corporate, or trust, as applicable.

Some states, however, impose alternative taxes or minimum fees on partnerships, especially LLCs, regardless of income. For instance, California and Tennessee impose annual franchise or excise taxes on LLCs, even if their income is zero.

Withholding on Nonresident Partners and Composite Filings

States are increasingly focused on ensuring tax compliance by nonresident partners. Common mechanisms include:

• Withholding Requirements: Partnerships may be required to withhold state income tax on nonresident partners’ distributive shares, remitting the withheld tax to the state. The nonresident partner can then claim the withholding as a credit on their state return.
• Composite Returns: Some states allow or require partnerships to file composite returns for nonresident partners, paying state income tax collectively on their behalf. This simplifies compliance but may forgo certain deductions or credits.

Withholding and composite filing rules vary by state, and some states impose penalties for failure to comply. Partnerships must track partner residency status and coordinate with their partners regarding filing choices.

Tiered Partnership Structures and Special Considerations

Tiered partnerships—where a partnership owns interests in other partnerships—add further complexity. States may require upper-tier partnerships to withhold or file composite returns for their own nonresident partners, even if the underlying income is already subject to withholding at a lower tier.

Additionally, some states have special rules for publicly traded partnerships or investment partnerships, which may affect filing and tax obligations.

Common State Taxation Issues Across Entity Types:

Apportionment formulas and sourcing rules differ significantly across states, and the impact of these variations can be substantial for businesses operating in multiple jurisdictions. Apportionment determines how much of a business’s income is subject to tax in a particular state, and the formula used can affect the overall tax liability.

While most states have adopted a single sales factor formula—where only sales are considered when apportioning income—some states still rely on a three-factor formula that incorporates sales, property, and payroll. The three-factor approach aims to reflect a company’s overall economic presence in the state, but the double-weighting of the sales factor, which some states use, further emphasizes the role of sales in the apportionment calculation. The choice of formula can result in dramatically different tax outcomes depending on how a business is structured and where its operations, employees, and customers are located.

Sourcing rules, which govern how sales of services and intangible property are assigned to a state, add another layer of complexity. For tangible goods, sales are generally sourced to the destination state—the state where the product is delivered. However, for services and intangible property, states are split between “market-based sourcing” and “cost of performance” approaches.

• Market-based sourcing taxes sales where the customer receives the benefit of the service or intangible property, focusing on the location of the customer.
• Cost of performance taxes sales based on where the service is actually performed, emphasizing the provider’s location.

Some states use hybrid rules or apply different sourcing for specific industries or types of transactions. These differences can lead to the same income being taxed by multiple states, especially when one state sources income to the location of the customer and another to the location of the service provider. Conversely, if neither state claims the income under their rules, it may escape taxation entirely—a phenomenon known as “nowhere income.”

Double Taxation Risks and Resident Credits

Double taxation occurs when the same income is taxed by more than one state, often because of inconsistent apportionment or sourcing rules, or due to throwback provisions. For example, a sale might be sourced to the destination state by one state and to the origin state by another, resulting in both taxing the same income.

Resident credits are designed to mitigate double taxation, allowing taxpayers to claim a credit for taxes paid to other states on the same income. However, the availability and calculation of resident credits differ by state and may be limited when taxes are imposed at the entity level rather than the owner level (or vice versa).

Gross Receipts Taxes, Minimum Fees, and Other Levies

Beyond income taxes, many states and localities impose gross receipts taxes, minimum fees, or franchise taxes, which may apply regardless of profitability or entity structure. These taxes are generally not creditable against income taxes and can represent a significant cost for businesses with large revenues but slim margins.

• Gross Receipts Taxes: Imposed on total receipts, not net income (e.g., Ohio CAT, Washington B&O, Oregon CAT).
• Minimum Fees: Flat annual charges, often imposed on LLCs and corporations regardless of income (e.g., California LLC fee).
• Franchise Taxes: Based on capital, net worth, or a combination of factors (e.g., Texas Franchise Tax).

These levies often vary by entity type, industry, and state, requiring careful review to avoid unexpected liabilities.

Local Taxes and Unique State-Specific Rules

In addition to state-level taxes, many cities and counties impose their own income, gross receipts, or business privilege taxes. Examples include New York City’s General Corporation Tax and Philadelphia’s Business Income and Receipts Tax. Local taxes may use different tax bases, rates, and apportionment methods than the state, creating additional complexity.

State-specific rules (such as special apportionment rules for certain industries, unique credits or incentives, and differing conformity with federal law) further complicate compliance and planning.