Effects of S Election on Domicile Should Be Considered in State Tax Planning

Many practitioners have set up S corporations for Federal purposes, without considering the tax implications at the state level. By not considering all of the available options, taxpayers may be paying excessive state taxes.

Example: Company X is incorporated in California by two 50% shareholders and elects S status for Federal tax purposes. One shareholder is a California resident and the other is a New York resident. The sales office is in California and the financial office is in New York. X makes sales all over the country, using the California sales office to solicit sales by telephone.

Under Quill Corp. v. North Dakota, 504 US 298 (1992), companies soliciting sales in another state without any substantial physical presence in that state may not be taxed by that state. Therefore, X files tax returns only in California and New York. Without careful planning, undesirable state tax consequences could occur. First, in the example, the tax effects of being commercially domiciled in California versus New York should be considered. Because the company has more employees in California, it may be assumed that the commercial domicile should be in California, in which case all sales to other states where income tax returns are not filed are apportioned to California. Simply put, California "throws back" all nontaxed sales to California. For example, if 15% of sales are to California customers and 10% of sales are to New York customers, 90% of the sales must be included in the apportionment factor, because New York is the only state where other returns are required to be filed. If, however, the commercial domicile is New York, the taxpayer will be taxed by New York only on New York-source income. Because New York law does not impose a throwback rule for sales, filing returns in other states is not relevant. In essence, some sales would not be taxed anywhere. In the example, with a New York domicile, 10% of the sales would be taxed by New York, 15% of the sales by California, and the other 75% not taxed anywhere. Obviously, if New York was considered the commercial domicile, it would be highly advantageous.

In general, a corporation's commercial domicile is the place from which its business is managed or directed, rather than the place in which the business assets are located and operated. In Pacific W. Oil Corp., 289 P2d 287 (Cal. Ct. App. 1955), the court mentioned numerous factors in determining commercial domicile, such as (1) the location at which payments were made, (2) where the principal accounting records were kept and (3) where the day-to-day management of the activities took place. In the example, all financial decisions, including credit approvals, payroll and other essential functions are performed in New York. X's only function in California is that of sales. Based on the analysis in Pacific W. Oil Corp, X would be considered commercially domiciled in New York.

Another factor to consider while analyzing the state tax consequences of a corporation is the effect of an S election. California recognizes an S election, unless official notification is given to the state. A company could be an S corporation for Federal tax purposes and elect to be treated as a C corporation for California purposes. As an S corporation, a company pays 1.5% tax on the apportioned net income. The income flowing to each shareholder from an S corporation is taxed at the individual level. For a shareholder resident in California, the entire flowthrough net income from the S corporation is taxed at graduated rates from 1% to 9.3%. Even though only 15% of the sales are from California sources, a resident shareholder must pay tax on 100% of his pro rata share of the flowthrough income from the S corporation. A nonresident shareholder pays tax only on the portion of income attributable to California. In the example, with the corporation domiciled in California, this would be on 90% of sales volume. If an S corporation elects to be a C corporation for California purposes, it pays tax at the corporate rate of 8.84% on apportioned taxable income. No further liability is incurred at the individual level except for distributions made by the corporation to a resident shareholder.

Likewise, in New York, a corporation may be an S corporation for Federal tax purposes and either an S or a C corporation for state tax purposes. However, contrary to California, to be an S corporation in New York, a corporation must affirmatively elect to be an S corporation; otherwise, it is a C corporation by default. An S corporation is taxed at a lower corporate rate of approximately 1%. Additionally, the flowthrough income is taxed at the individual level. A resident shareholder is taxed on 100% of his pro-rata share of the flowthrough income. Nonresident shareholders would be taxed on their apportioned income. In the example (with X domiciled New York), this would be 10% of the sales volume. In contrast, a New York C corporation is taxed at a higher corporate rate of 9%. However, the flowthrough income is not taxed at the individual level, except for distributions to a resident shareholder.

Although this analysis considers the effects of S corporations and domicile in New York and California, tax advisers should consider location when structuring their client's business in every state. It is important to determine if all states in which the corporation does business have an income/franchise tax, the standards for domicile (including potential alternatives), whether the state income tax laws include a throwback rule for sales to nontaxing jurisdictions, and finally, whether a Federal S election is always effective in the state where the corporation will be subject to tax. Further, advisers should look past the corporate entity to its shareholders and consider items such as state of residency.

From Cathy E. Lambert, Rehman Robson P.C., Farmington Hills, MI