Thinking Above and Below the Line for S Corporation Composite Taxes

A majority of states have recently adopted provisions that allow composite return filings by S corporations. Such filings ease shareholders' burdens by allowing the S corporation to file returns and make state tax payments on behalf of its nonresident shareholders. As "group filings" are a relatively new concept, there is little guidance on how such payments should properly be treated for Federal tax purposes.

Ordinarily, individuals are not entitled to "above the line" deductions for state income taxes paid on business profits (Rev. Rul. 70-40). On this basis, one might argue that the payment of the taxes by the corporation should result in deemed distributions to the shareholders, who could deduct the taxes as itemized deductions on their individual tax returns. However, if the individuals do not itemize deductions (or if their itemized deductions are limited), they may lose the benefit of all or part of the state tax deduction.

Alternatively, taxes paid by an S corporation in a group filing can be easily differentiated from an individual's state income taxes, in that the payments being made by the corporation are specifically authorized by state statutes. On this basis and on the basis of Sec. 164(e) and Regs. Sec. 1.164-7, it could be argued that such payments are deductible by the S corporation and are not deemed distributions to the shareholders. Under this scenario, the net result would be an above-the-line deduction to each shareholder for his proportionate share of the state composite taxes paid. Additionally, this deduction would not be treated as a tax preference item to the individual shareholders for alternative minimum tax purposes.

Sec. 164(e) states:

Where a corporation pays a tax imposed on a shareholder on his interest as a shareholder, and where the shareholder does not reimburse the corporation, then the deduction allowed by subsection (a) shall be allowed to the corporation; and no deduction shall be allowed to the shareholder for such tax.

This section is applicable to S corporations under Sec. 1371(a), which states that for tax purposes, unless otherwise provided, an S corporation is treated the same as a C corporation. Because the deduction is not allowed to the shareholder, it is not an item that could affect the tax liability of any shareholder (as described in Sec. 1366(a)(1)(A)). Consequently, the deduction is taken into account in determining the S corporation's nonseparately computed income or loss (Sec. 1366(a)(2)).

This provision for the corporate deduction of taxes imposed on "his interest as a shareholder" first appeared in 1921 and became the current Sec. 164(e) in 1954. The provision was enacted to allow banks to deduct taxes paid on shares of stock in the banks. While this may have been its original intent, a literal reading of Sec. 164(e) arguably permits the corporate deduction of state composite taxes paid by a corporation, as such taxes are imposed by reason of the individual's stock ownership. If the individual were not a stockholder, there would be no state tax liability to that individual as a result of the S corporation's income.

While deducting the state composite taxes paid at the S level would almost always be more beneficial from a Federal tax perspective, state tax consequences should also be considered. In states with no individual income tax, the benefit is easily measured. However, in "high" tax states such as New York, taking the deduction above the line may actually cause an increase in the individual's overall tax liability. In theory, given that the taxes are treated as paid at the S level, the individual must forfeit the right to claim a dollar-for-dollar state tax credit (subject to certain limits) for composite taxes paid to other jurisdictions, as the deduction belongs to the corporation.

The only guidance from the Service on this issue has been Letter Ruling 9142029, in which the IRS ruled that payment of state income taxes by an S corporation by way of a group filing was the same as if the corporation had distributed the amounts to the shareholders who then paid the taxes. As a result, the shareholders would presumably include the distributed amounts in income and take a corresponding itemized deduction, if applicable. Unfortunately, the Service failed to address the possible application of Sec. 164(e) in its analysis. Query: Should the deduction for state composite taxes paid be "above" or "below" the line?

From Allyson Hayes and Jeffrey A. Kelson, CPA, New York, NY