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The U.S. allows pass-through treatment for partnerships and limited liability companies for federal income tax purposes. The issue remains how such entities and their owners will be taxed in those states and localities that impose income taxes. Most states and localities will respect the pass-through treatment of pass-through entities when applying their local income taxes. However, there are other state and local tax issues and consequences that relate to pass-through entities that can yield surprising or unexpected results. A recent article discusses some of these.

In regard to taxes imposed directly on the entity, some states will still impose entity level taxes on pass-through entities. Examples include the New Hampshire business profits tax, Tennessee corporate excise and franchise taxes, New York City taxes on ?S? corporations and unincorporated entities, and the Texas margin tax on limited liability entities.

States may also impose substantial fees on the entities. These may be based on dollar amounts per member, a percentage of income or assets, or a flat annual fee. At times, if the fees are material enough, they could be subject to challenge under Constitutional apportionment principles.

States and localities may impose estimated and/or withholding taxes on nonresident owners. These taxes may be imposed without regard to actual distributions from the entities, can create real cash flow issues for entities, could put entities at risk of violating loan covenants that restrict distributions or expenditures to or for the benefit of owners, and can create disproportionate distribution issues since such taxes are often not imposed on all owners.

A related and somewhat complex issue is state and local income taxes of owners on the income of the entity. Different regimes may impose different results based on residency of the owners, residency of the entity, types of income incurred, and may create double taxation issues when full credit for taxes imposed by other jurisdictions is not granted.

Clearly, tax planning for pass-through entities cannot be limited to federal taxes - applicable state and local tax issues also must be reviewed.

State Taxation of Taxation of Partnerships, Limited Liability Companies, and Their Owners, Business Entities (WG&L), Sep/Oct 2009 by Carolyn Joy Lee, Bruce P. Ely, and Dennis Rimkunas

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