Editor: Mary Van Leuven, J.D., LL.M.
Partners & Partnerships
To withhold, or not to withhold? That is the question faced by many partnerships conducting business in multiple states. Not only might a partnership be required to withhold or make payments on behalf of partners in states where it is operating, but a few states also require a partnership to file information returns in states where any of its partners are located. The varying rules for withholding can create a compliance nightmare for multistate partnerships with a large number of partners.
For starters, the terminology used in state statutes can be confusing. For example: Does a “corporation” include an S corporation? Does a “partnership” include a limited liability company? States often use the terms “withholding” and “estimated payments” somewhat interchangeably. (For purposes of this item, “withholding” generally will mean a single, year-end payment, while “estimated tax payments” will be used when a state requires multiple payments at defined periods throughout the year, e.g., quarterly.) When researching these issues, a tax practitioner must carefully consider definitions as well as the substantive rules applicable for a given state.
Withholding requirements often vary depending on the partner’s classification (e.g., individual, corporation, etc.). Almost all states provide some exemptions for certain types of partners, but these vary significantly. A tax practitioner effectively must consider the tax rules applicable to each partner in each state. Such considerations can be daunting when advising large, multistate partnerships.
Adding to the already complex compliance rules for taxpayers and practitioners, a handful of states, including Idaho, New Mexico, and Michigan, have modified their partnership withholding/estimated tax laws. This item discusses general rules as well as some of the changes that should be considered during the current filing season.
General Rules and Common Exceptions
As stated, withholding requirements often vary depending on the partner’s classification (e.g., individual, corporation, etc.). The tax rate that generally applies is the highest marginal rate for the partner’s entity type. Many states impose partnership withholding on nonresident individual partners. Some also require withholding for resident individuals and corporate partners. New York, for example, requires withholding for nonresident individuals and all corporations, whether or not they are domiciled or located in New York (N.Y. Tax Law §658(c)(4)(A)).
The withholding requirements for tiered partnerships (i.e., a partnership that owns an interest in another partnership) can be complex. Some states require a lower-tier partnership to look through the partnership partner and determine withholding based on the ultimate owner of the partnership (see, e.g., Ind. Dep’t of Rev., Income Tax Information Bulletin No. 85 (January 2003)). Thankfully, a few states have realized how difficult this can be and exempt from withholding any partner that is itself a passthrough entity (see, e.g., Colo. Taxpayer Serv. Div., FYI Income 54, Nonresident Partners and Shareholders of Partnerships and S Corporations (March 2010)).
Partnerships may qualify for various exemptions from withholding, if eligible. Naturally, the criteria for exemptions, like the multitude of other issues concerning partnership withholding, vary from state to state.
Many states do not require withholding below certain income thresholds. For example, several require withholding only if the partner’s distributive share of state taxable income is $1,000 or more. (See, e.g., Conn. Gen. Stat. §12-719(b)(2)(C)(1); 18-125 Code Me. R. §803(6)(3)(A)(1); Minn. Stat. §290.92.4b(d)(2); N.D. Cent. Code §57-38-31.1(3)(c)(1); R.I. Gen. Laws §44-11-2.2(c)(1); Wis. Stat. §71.775(3)(a)(2)). Other minimum income requirements may apply in other states.
Some states do not require withholding if certain tax thresholds are not met. For example, New York requires estimated taxes to be paid on behalf of a nonresident partner only if the partner’s tax is more than $300 (N.Y. Tax Law §658(c)(4)(D)(i)).
Many states provide an exemption if the owner provides the passthrough entity with a waiver form. An exemption waiver form typically provides that the nonresident owner is tax-exempt or, if not exempt, the partner agrees to timely file and pay any tax due on its distributive share of income sourced to the state. Completing a waiver may be attractive to nonresidents that otherwise are required to file an income tax return with the state (e.g., the nonresident may have income from other sources within the state). Generally, a separate agreement is required for each nonresident owner and must be maintained by the partnership. When partnership interests change hands frequently, maintaining an accurate file of waivers can be challenging.
Some states allow a partner to elect participation in a composite return. The partnership then files a return and makes payments on behalf of its nonresident partners. In most states, the filing of a composite return is optional. However, in Alabama, the partnership is required to file a composite return on behalf of nonresident partners and pay income tax imposed at the highest marginal rate (Ala. Code §40-18-24.2(b)(1)).
The following paragraphs discuss some of the current developments relating to partnership withholding and estimated payments.
Idaho: Effective Jan. 1, 2012, Idaho implemented new rules for withholding on a partner’s distributive share of income (Idaho Code §63-3036B). The legislation allows individual partners to elect to have the partnership report and pay tax at the rate applicable to corporations. However, such an election is not available to residents or to a nonresident individual who has taxable income in addition to income subject to the election. Thus, if the nonresident partner has other income from Idaho not stemming from the partnership, e.g., income from employment in Idaho with a nonaffiliated company, this election is not available (Idaho Code §63-3022L). If the nonresident partner does not elect to be included in the combined return, the partnership must withhold tax at the highest marginal rate applicable to individuals, trusts, and estates for the tax year (Idaho Code §63-3036B).
Michigan: Michigan overhauled its income tax system, including the way partnership income is taxed. Previously, partnerships were subject to the entity-level Michigan business tax (MBT). Under the new corporate income tax (CIT), effective Jan. 1, 2012, partnerships are not subject to any income taxes. Instead, following the model of other states, partnership income and factors pass through to the partners. Partnerships will be required to make quarterly estimated payments of tax on the expected distributive share of income attributable to nonresident individual partners. If a partnership generates more than $200,000 in business income after apportionment and allocation, the partnership must also make quarterly estimated payments on the expected distributive share of business income for each member that is a corporation or passthrough entity (Mich. Comp. Laws §§206.703(3) and (4)).
Kentucky: Effective for tax years beginning after Dec. 31, 2011, Kentucky adopted statutory minimum thresholds for paying estimated taxes on behalf of partners. For nonresident individual partners, estimated payments will be required if the estimated tax liability for that partner can reasonably be expected to exceed $500. For a corporate partner that is doing business in Kentucky only through its ownership interest in the partners, estimated payments are required if the estimated tax liability for that partner can reasonably be expected to exceed $5,000 (Ky. Rev. Stat. §141.206(6)).
Maine: Effective Jan. 1, 2012, Maine will no longer require a partnership to file a return in the state if the partnership’s sole connection to Maine is a partner that is a resident of Maine. Previously, Maine, like a handful of other states, required the partnership to file an information return in the state, even when the partnership did not engage in business in the state, if a partner of the partnership resided in the state.
In addition, Maine changed the filing requirements for certain partnership forms. Form 941P-ME, Pass-Through Entity Return of Maine Income Tax Withheld From Members, which previously was required to be filed quarterly, will be replaced effective for calendar years 2012 and after by an annual Form 941P-ME. The new form will be due Jan. 31 following the calendar year for which it is filed. It is important to note, however, that although the quarterly reports have been discontinued, quarterly payments of tax are still required and the due dates remain unchanged (i.e., the last day of the month following the end of the quarter) (Me. Rev. Servs., 21(8) Maine Tax Alert 4 (November 2011)).
New Mexico: New Mexico has also revised the withholding requirements for partnerships. Under the previous withholding structure, a partnership was required to make estimated tax payments for all nonresident owners that did not agree to report and pay New Mexico income taxes. Effective Jan. 1, 2011, a partnership is required to make quarterly income tax payments on every nonresident owner’s share of net income (N.M. Stat. §7-3A-3(B)). If the partnership does not make quarterly payments, the partnership is liable for the tax if the owner subsequently fails to pay (N.M. Stat. §7-3-5(A)). Payment is not required if the amount to be withheld from an owner’s share of net income in any calendar quarter is less than $30 (N.M. Stat. §7-3A-3(G)).
The withholding requirement does not apply to partners that are resident corporations or individuals, U.S. government entities, federally recognized Indian tribes, and organizations exempt from tax under Sec. 501(c)(3) (N.M. Stat. §7-3A-3(C)).
Changes in this area may be subtle and could easily go unnoticed; thus, it is prudent for the partnership and return preparer to be aware of each of the filing states’ specific rules to preclude any assessment of penalties. While some states, such as Maine, revised and eased their withholding requirements to reduce the administrative burden, other states instituted changes that compound the complexity partnerships already face. The variation in the states’ approaches to partnership nonresident withholding presents numerous challenges for partnerships and tax return preparers. The topics addressed above represent only a few of the important withholding issues partnerships encounter. Thus, it is vital to understand each state’s rules and the nuances that exist among them.
Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or email@example.com.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.