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Many businesses operate in multiple states which creates different tax issues. For flow-through entities such as partnerships and S Corporations, the business activity in each state can create a filing requirement in that state for all of its partners or shareholders. This is where the decision must be made as to whether or not to file a composite tax return.
A composite return is a tax return filed and paid at the entity level on behalf of the non-resident partners or shareholders. Each state has its own rules on eligibility and even the availability of filing a composite tax return, so it is important to be aware of the tax laws in each state. The largest benefit of filing a composite return is the convenience of filing only one state return at the entity level instead of filing returns for each non-resident. This benefit will also result in lower tax preparation fees and put the burden of notices and assessments on the entity and not on the partners/shareholders. However, the convenience comes at the cost of the payment of the tax; most states have the tax rate at the highest marginal rate which may not apply to every partner/shareholder. The tax payment on behalf of the partners/shareholders is also not a deduction at the entity level but treated as a distribution and payment on behalf of the non-resident. While this allows the partners/shareholders to use the payments as a state income tax deduction; it also can create disproportionate distributions which can be problematic when maintaining partnership capital accounts or proportionate S corporation distributions. If the business has a loss in the state, then generally it does not carryforward on a composite return, thus losing the partner’s/shareholder’s ability to carry it forward to future years.
Other considerations include the number of partners and their relative tax brackets, partner/shareholder eligibility for a composite return, and the statute of limitations to filing a return in each state. It is important to note that composite returns are elective each year so filing in one tax year may make more sense than others. That is why it is important to have a discussion with your RINA tax advisor regarding the benefits and costs of filing a composite return.