Tax Payments by Passthrough Entities for Nonresident Owners

Many states have begun to require flowthrough entities to either withhold or pay estimated taxes for their nonresident partners, members and shareholders. This requirement can create many economic, contractual and statutory problems. In extreme economic situations, for example, passthrough entities have had to secure additional financing or resort to capital calls from the affected owners to make required payments.

Contractual Problems

The contractual issue arises if such payments are precluded by contract with third parties or by owner agreement (i.e., in a partnership or shareholder agreement or limited liability company (LLC) operating agreement). Many financing agreements limit or preclude distributions to owners until certain conditions are met. Agreements with regulatory or state funding agencies may place similar restrictions on the timing and amount of distributions to owners. Such restrictions are common in the funding of low-income housing projects, both in the initial financing of the construction and the operational rent subsidies made available to tenants. Partnerships that are providing affordable housing are generally precluded by the municipal housing agency from making distributions to the partners until certain performance levels are reached. Payments on behalf of nonresident partners can trigger a breach of the agreement; the municipality may terminate the housings funding or the tax-exempt status of any municipal bonds issued.

Many partnership/operating agreements provide for distributions based on the class of the partner. A violation of the agreement may occur if a distribution is required to be made on behalf of certain partners/members due to their status as nonresidents, before distributions are made to those with higher distribution priorities.

Statutory Issues

The last problem area is the statutory one. S corporations have to make distributions in proportion to stock ownership. Thus, if an estimated/withholding tax payment is made on behalf of a nonresident shareholder and treated as a distribution, proportionate distributions must be made to the remaining shareholders. The entitys cashflow may be inadequate to permit distributions to all shareholders. Some tax advisers treat the tax payments as loans to nonresident shareholders, which can be repaid either from future distributions or directly by the shareholder.

Miscellaneous Questions

Other complexities that arise as a result of new state requirements for payments on behalf of nonresident owners result from the lack of uniformity from state to state, both in the calculation of amounts to be remitted and the timing of payments. Some states base the required payment on the prior-years taxable income; other states base it on the current-years estimated income.

The treatment of payments also varies from state to state. Some states consider the payments as withholding taxes, while others treat them as estimated taxes. The difference lies in the timing of the credit for the payment claimed on the owners return when calculating any penalty for underpayment of estimated taxes.

Another administrative difficulty that arises is tracking the residency status of partners/members/shareholders. The owners mailing address may not provide a reliable basis from which to determine the state of residence.

From David Schneyman, CPA,  Friedman, Alpren & Green, New York, NY