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.
Additional Information You May Find Useful
If you want additional information about how to maximize the tax savings related to running a business or investment venture, you may also be interested in one of our downloadable e-books (see descriptions below). Each book covers a category of tax planning topics that easily save a business owner significant amounts of income or self-employment taxes (potentially thousands of dollars a year) and is instantly downloadable.
Often the best tax saving tool private companies have? The Section 199A deduction which allows them to avoid taxes on the last 20 percent of their income.Read More
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Nearly secret, the federal government's employee retention credits provide tremendous payroll tax savings for most small businesses... A new book from our firm explains.Info here