Law Firm Composite Returns: To Participate or Not To Participate?
Law firms operating in a multi-state environment expose their partners or non-resident shareholders to income tax liabilities and filing requirements wherever the firm has nexus.1 It can be an administrative and financial burden for each partner to file estimated taxes, extensions and final income tax returns in a multitude of states.
Fortunately, most states offer a composite or group tax return option which consolidates the qualified electing non-resident partners’ tax reporting into a single tax return. A composite filing is certainly convenient for the partners: They are relieved of the burdensome state reporting responsibilities and share the streamlined compliance costs with their partners.
Although the composite concept is indeed straightforward and logical, its practical application is often quite the opposite. States have complete autonomy in developing their approach to group filings and their varied rubrics and qualifications require that the decision be made thoughtfully and with the appropriate professional advice.
The qualifications for participation vary widely among taxing jurisdictions. A composite participant is usually required to have been a non-resident of the state for the entire year. The majority of states prohibit inclusion if a non-resident taxpayer (or spouse) has other sources of income from the non-resident state -- a consideration for lateral partners receiving a K-1 from both the former and current firms. Nevertheless, some states explicitly allow nonresidents to participate in more than one composite filing -- so that a partner with multiple K-1s from a given state might be able to be included in two composite returns in that state. Some states also require a minimum number of partners to be allowed to file on a composite basis.
There are other potential drawbacks to choosing the group approach, depending upon a partner’s specific tax position. Through inclusion in a composite/group return rather than an individual non-resident tax filing, a partner often forfeits the tax benefits of exemptions and deductions. Another significant trade-off is that the majority of states impose their highest personal income tax rate on the income of each partner included in the composite return. Notably, inclusion in a filed composite does not start the statute of limitations for any of the individual participants with regard to other state issues. If at some future point, for example, a state determines that a particular partner should have filed as a resident or uncovers taxable income that should have been reported in a prior year, the year remains open for assessment purposes.
S corporations must make distributions pro rata, or strictly in proportion to the shareholder’s ownership percentage in the entity. Composite payments can produce disproportionate distributions where participating partners are taxed at a higher rate than either resident or non-participating partners and the former receive larger distributions to satisfy their resulting tax liability. S corporations should institute annual corrective distributions to avoid jeopardizing the entity’s S election.
Each non-resident partner should carefully consider whether or not to participate in one or more of a firm’s state composite income tax returns. The first consideration is whether the partner qualifies to be included the composite filing in a particular state (i.e., was the partner a nonresident for full year, is the K-1 the partners only source of income in that state, etc.). Other considerations are the impact of any lost deductions and maximum tax rates in the composite filing vs. the cost of paying for your accountant to prepare additional non-resident returns. It is not unusual for a partner to elect to be included in some composite filings filed by a firm but not all. For example, application of the highest marginal rate has little impact when a partner’s income from that state is relatively insignificant. In that case, the cost of individual compliance may well outweigh the rate differential. Alternatively, a partner may not be adversely affected by a high tax rate and loss of deductions in composite filings if that partner’s resident state tax is relatively high and the resident jurisdiction allows a generous credit for taxes paid to other states. To this end, the firm should present the alternatives as early as possible in the process and allow time for the partners to consider each state’s composite options and to communicate with their personal tax advisors. Both firms and partners must plan ahead because certain states mandate an application and/or specific consent procedures well before the actual tax filings.
1 Law firms organized as pass-through entities – partnerships or Scorporations -- pass taxable income through to their individual owners. For simplicity, we will use the term “partner” here to refer to the firm’s owners in the general discussion.