A number of states impose an entity-level tax on pass-through entities (PTEs). Under federal tax law, a PTE is not taxed at the entity level. The income or loss flows through to the owners, partners, shareholders, or members. While states follow the federal tax treatment of passing through income or loss, smart tax planning requires knowing which states do and which do not.
How Do States Tax Pass-Through Entity Income?
Most states follow the federal tax treatment of passing through income and loss to owners of PTEs. In doing so, most recognize the federal classification of entities provided under the federal check-the-box regulations.
What Are the Check-the-Box Rules?
The federal rule determining how PTEs, other than S corporations, are taxed is commonly referred to as the “check-the-box” rule. An eligible entity’s owners check a box on federal Form 8832 electing how the entity prefers to be taxed. The entity owners choose whether to classify the eligible entity as:
- a regular corporation; or
- as a partnership.
If an eligible entity does not fill out the form, the entity is generally classified as a partnership by default.
Most states conform to the federal classification under the check-the-box regulations. So an entity treated as a partnership for federal tax purposes is also treated as a partnership for state tax purposes and receives flow-through taxation.
Who Pays Tax on Pass-Through Income?
The PTE must send each of its owners a Schedule K-1 of Form 1065 detailing the owner’s distributive share of federal:
- deductions, and
Each owner reports these items on its respective return and pays tax based on the owner’s tax rate.
How Are Entity-Level Taxes Imposed?
States that tax PTEs at the entity level do so in various ways. Types of taxes that must be paid by the entity include:
- Income tax
- Excise tax on net earnings
- Franchise tax on net worth or actual value of tangible property
- Personal property replacement income tax
- Business privilege tax on taxable net worth
- Flat annual tax
How Are S Corporations Taxed?
S corporations receive pass-through tax treatment at the federal level. Most, but not all, states follow federal treatment for S corporations.
States, and the District of Columbia, that tax S corporations at the entity level, in the same manner as other corporations, include:
- District of Columbia
- New Hampshire
How Are Limited Liability Partnerships Taxed?
Limited liability partnerships (LLPs) receive pass-through tax treatment at the federal level. Again, most states follow federal tax law.
States that do not recognize the federal classification of LLPs and tax LLPs at the entity level include:
- New Hampshire
Texas does not tax LLPs at the entity level if they are passive partnerships.
How Are Limited Liability Companies Taxed?
Limited liability companies (LLCs) receive pass-through tax treatment at the federal level. While most states follow federal, states that do not recognize the federal classification of LLCs and tax them at the entity level include:
- New Hampshire
What Are Some Other Examples of Entity Level Taxes?
States impose entity level taxes in various ways.
California imposes different entity level taxes depending on the type of entity:
- An annual tax on limited partnerships and LLPs;
- An income tax on S corporations; and
- A fee based on income for LLCs.
- A PTE tax; and
- A $250 biennial assessment, known as business entity tax.
The District of Columbia imposes a franchise tax on taxable income.
Illinois imposes a personal property replacement income tax.
Kentucky imposes a limited liability entity tax on S corporations and limited liability pass-through entities. General partnerships are excluded from the tax.
By Tralawney Trueblood, J.D., M.B.A.