Firstly, transitioning a portion of the business to a C corporation means that the income will be subject to corporate income tax rates, which are generally higher than individual rates applied to S corporation income.
C corporations face double taxation, where income is taxed at the corporate level and again at the shareholder level when dividends are distributed . The remaining S corporation portion will continue to pass income directly to shareholders, who will report it on their personal tax returns, potentially benefiting from lower individual tax rates .
Additionally, the change in structure may affect the business's eligibility for certain tax credits and deductions, as C corporations and S corporations have different rules regarding these benefits . The business must also consider state-level tax implications, as states may have different rules for C corporations and S corporations, affecting state income tax liabilities . Furthermore, the transition could impact the business's ability to utilize tax attributes such as net operating losses, which are treated differently under C corporation and S corporation structures.
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This portfolio discusses the principal state tax issues that should be addressed in structuring a business in pass-through form. The portfolio describes and compares the state tax provisions applicable to the most commonly used pass-through entities (e.g., partnerships, LLCs, S corporations, real estate investment trusts, and mutual funds); the treatment of different types of participants in such entities; jurisdictional issues presented by nonresident and corporate participants; the application of state allocation and apportionment rules to pass-through entities and their participants; and the various mechanisms used by the states to increase compliance with filing and tax payment obligations. The portfolio does not attempt to catalogue each of the specific state tax rules applicable to pass-through entities and their participants, but rather to identify important issues and differences in the approaches taken by the states that can aid the reader in structuring the entity in the most tax-advantaged manner. Wherever possible, planning opportunities (termed “Planning Points”) are identified to assist the reader in recognizing the potential for state tax savings presented by these rules.
Recent developments affecting pass-through entities involve jurisdictional questions and apportionment issues. States often maintain that ownership of an interest in a pass-through entity that does business in a given state is sufficient to give that state jurisdiction over a nonresident owner. In some cases, states seem to be pushing the limits of what is constitutionally permissible in their attempts to tax nonresident owners.
Presenting a challenge to pass-through entities and their owners, as well as to practitioners, state taxation rules vary widely and change often. As discussed in the ensuing chapters, the principal state income tax issues with respect to pass-through entities and their owners include:
• conformity to federal flow-through tax treatment of pass-through entity income;
• state entity-level taxes;
• nexus considerations for corporate partners and LLC members;
• apportionment of a corporate owner's distributive share of pass-through entity income;
• state taxation of partners and other owners who are individuals; and
• composite return and withholding requirements.
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