In a prior life, I worked in a tax department where we managed the filing of multistate income tax returns and the flood of notices received for over 500 pass-through entities. The group of entities included multi-tiered partnerships, limited liability companies with single-member limited liability companies and S corporations with Q-subs. Consequently, nonresident withholding was a major issue for us and the state tax departments with which returns were filed.
If you or your client operates within a pass-through entity such as a S corporation, partnership or limited liability company, then you know what nonresident withholding is.
In basic terms, nonresident withholding is when a state requires a pass-through entity to withhold state income tax (or make a state tax payment) on a nonresident shareholder's pro rata share of the pass-through entity's income sourced to the specific state. In other words, it is a mechanism for states to better ensure that state tax will be paid by nonresident shareholders.
Now, if you or your client operates within a multi-tiered structure of pass-through entities, then nonresident withholding can become a compliance nightmare for both you and state taxing authorities. Most states have difficulty tracking nonresident withholding when it passes through multiple layers before it gets to the ultimate taxpayer. Therefore, state tax notices upon state tax notices can become an unwelcome, but familiar friend.
With that said, here are a few tips or questions to ask when dealing with nonresident withholding in multi-tiered structures:
- Does the state require quarterly nonresident withholding on actual payments/distributions or on allocated income? To put it simply, some states only require quarterly nonresident withholding if a cash payment is actually made to a shareholder. If states don't require quarterly nonresident withholding, most, if not all states require annual nonresident withholding on "allocated income" whether a distribution is actually paid or not.
- Is nonresident withholding required to be done for all nonresident shareholders regardless of the type of shareholder? Meaning, is withholding required for C corp, S corp, partnership, LLCs, individual and/or trust shareholders?
- Does the state allow or have a mechanism for nonresident shareholders to obtain a waiver or exemption from nonresident withholding? Meaning, can a nonresident shareholder provide the pass-through entity or the state with a document to keep the pass-through entity from withholding on its share of the state's source income?
- Is the nonresident withholding required to be done on a quarterly basis? Or can it be paid one time a year?
- In a multi-tiered pass-through entity structure, at what level is nonresident withholding required to be done? Meaning, is the lowest entity required to do the withholding or does the state only require the entity before the ultimate taxpayer to do the withholding? This is a key question, because if it is done at the wrong level, it can cause great confusion and an explosion of notices between the state and the taxpayer.
Some of the top problem states when dealing with nonresident withholding are: California, Colorado, Indiana, and Iowa. Kansas used to be a pain, but withholding is no longer required after July 1, 2014. These are just a few. As I stated earlier, in a multi-tiered structure, nonresident withholding is a tracking 'nightmare' for both the taxpayer and the state. Obviously, it requires meticulous record keeping to get it right.