Recent Developments in the State Taxation of Pass-Through Entities and Their Owners

State and local taxation of pass-through entities continues to present complex issues for the owners of those entities, especially when the pass-through entities are conducting business in multiple states. Compared with resident owners over which a state has jurisdiction because of their physical presence in the state, nonresident owners of passthrough entities are presented with more difficult issues. As a way to collect additional revenue and potentially avoid difficult constitutional questions involving how to tax nonresidents, many states have enacted entity-level taxes or withholding or composite return requirements.

Applying these entity-level taxes and withholding/composite return requirements, however, presents states with a variety of issues. States may look to federal income tax law when imposing net-income based taxes on pass-through entities. However, for multiple reasons, applying federal rules at the state and local level often presents more questions than it answers. First, the federal rules do not address jurisdictional issues in a domestic context. Second, domestic entities must only comply with one federal taxing regime, while multistate pass-through entities must comply with the taxing systems of each state in which they have nexus.