Pass-Through Entities Face Myriad State-Level Taxes, Compliance Obligations

Pass-through entities, such as partnerships, limited liability companies, and S corporations (collectively, “PTEs”), are the most widely chosen forms of business entities in the U.S. because they escape tax at the entity level for federal income tax purposes. Instead, the federal tax laws allow the income of the PTE to flow through to its owners (e.g., partners, LLC members, or S corporation shareholders) before being subject to the appropriate individual or corporate income tax.

Taxation of PTEs, however, can be very different at the state level. Some states impose tax not only at the individual level but also at the entity level, while some that don’t have an individual income tax impose an income tax directly on income of the PTEs. While PTEs are commonly owned by individuals, states are increasingly applying corporate income tax concepts, such as business or nonbusiness income classification and apportionment, to PTEs that operate in more than one state. It is frequently unclear how each jurisdiction applies these concepts. The lack of clarity on how states tax these entities creates significant risks for these businesses and their tax advisers.

Bruce P. Ely and Steven N. Wlodychak share some of their key findings from their years of experience working on PTE tax matters at the state level.

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