How Do States Treat S Corporations?

Great question. Unfortunately, the answer is a little complicated.

Perhaps the first thing to know, however, is that generally states treat S corporations the same way that the federal government treats S corporations. For example, if you make a valid S election with the IRS for federal income tax purposes, most often your state also honors that federal S election for state purposes. As another example, in general, S corporation shareholders are subject to state income taxes on their proportional shares of the S corporation's profit--just as they're subject to federal income taxes on their proportional shares of the S corporation's profit.

Numerous little exceptions to these general rules exist, however:

Not All States Recognize S Corporations

Some states do not recognize S corporations--in other words, they treat S Corporations like C corporations. At the time of this writing, the District of Columbia, New Hampshire, and Tennessee fall into this category. Note that you can still have an S corporation in these states--and that can still mean big federal tax savings--but the S corporation will only be an S corporation for federal tax purposes and not for state tax purposes. For state purposes, the corporation will be treated as a regular C corporation.

Some States Tax S Corporations

Some states tax S corporations on part of their income even though they do recognize the S corporation. For example, Massachusetts taxes S corporations on their profits when the profits rise about a specified limit. (Note: Shareholders in Massachusetts S corporations are not taxed on their shares of this "taxed" S corporation income.) And several other states tax shareholders on the S corporation's income and also tax the S corporation on some of its income. For example, in both Indiana and Kentucky, while shareholders are taxed on their proportional shares of the S corporation's profits (meaning the state has taxed all of the business's income), the S corporation also pays taxes again on capital gains and on excess passive income. Idaho, Maine and Wisconsin play a similar game with S corporations.

Some States Tax S Corporations and Their Shareholders

A small handful of states, including Michigan, California, New Jersey and New York, tax both the S corporation's profit and the shareholder's proportional shares of the S corporation's profits. This means that in a sense the S corporation is double-taxed in a manner similar to a C corporation that, distributes all of its profits as dividends.

Michigan, for example, taxes the S corporation shareholder on all of his or her income because Michigan does recognize the federal S corporation election for purposes of passing through S corporation profits to shareholders. Michigan also taxes the corporation on that same income via its single business tax. Fortunately, most small businesses--the sorts that would elect S corporation status--either aren't subject to the single-business tax or don't pay very much single business tax. (At the time I'm writing this, a business is exempt from the single business tax if its gross receipts are less than $350,000. Michigan may just win the dubious honor of being the worst state in the nation to setup an S corporation.)

California, New York and New Jersey also tax both the corporation and the shareholder on business profits. Fortunately, in these three states, the state corporate tax rate levied on the S corporation's profits is modest. In California, for example, the S corporation tax is the greater of $800 a year or 1.5% of the S corporation's taxable income.

Multistate S Corporations Taxed in Multiple States

In general, if an S corporation does business in another state (other than the home resident state), that other state will want to tax all shareholders--even nonresident shareholders--on their proportional shares of the S corporation's income earned in that other state. Some states as a convenience let the S corporation pay the income taxes owed by shareholders or nonresident shareholders.

As a final general comment about the state taxation of S corporations, let me suggest that if you want to turn an LLC into an S corporation or if you want to set up a new S corporation, it's a good idea to call the state income tax agency where the S corporation will operate and ask two questions: One, whether there's a separate state S corporation election form that needs to be filled out, and, two, if they have any information they can provide to you concerning the taxation of S corporations. You obviously don't want to be surprised.

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