If you or your client operates within a pass-through entity such as a S corporation, partnership or limited liability company, then you know what nonresident withholding is.
In basic terms, "nonresident withholding" is when a state requires a pass-through entity to withhold state income tax (or make a state tax payment) on a nonresident shareholder's pro rata share of the pass-through entity's income sourced to the specific state. In other words, it is a mechanism for states to better ensure that state tax will be paid by nonresident shareholders.
Now, if you or your client operates within a multi-tiered structure of pass-through entities, then nonresident withholding can become a compliance "nightmare" for both you and state taxing authorities. Most states have difficulty tracking nonresident withholding when it passes through multiple layers before it gets to the ultimate taxpayer. Therefore, state tax notices upon state tax notices can become an unwelcome, but familiar friend.
With that said, here are a few tips or questions to ask when dealing with nonresident withholding in multi-tiered structures:
1) Does the state require quarterly nonresident withholding on "actual payments/distributions" or on "allocated income"? To put it simply, some states only require quarterly nonresident withholding if a cash payment is actually made to a shareholder. If states don't require quarterly nonresident withholding, most, if not all states require annual nonresident withholding on "allocated income" whether a distribution is actually paid or not.
2) Is nonresident withholding required to be done for all nonresident shareholders regardless of the type of shareholder? Meaning, is withholding required for C corp, S corp, partnership, LLCs, individual and/or trust shareholders?
3) Does the state allow or have a mechanism for nonresident shareholders to obtain a waiver or exemption from nonresident withholding? Meaning, can a nonresident shareholder provide the pass-through entity or the state with a document to keep the pass-through entity from withholding on its share of the state's source income?
4) Is the nonresident withholding required to be done on a quarterly basis? Or can it be paid one time a year?
5) In a multi-tiered pass-through entity structure, at what level is nonresident withholding required to be done? Meaning, is the lowest entity required to do the withholding or does the state only require the entity before the ultimate taxpayer to do the withholding? This is a key question, because if it is done at the wrong level, it can cause great confusion and an explosion of notices between the state and the taxpayer.
Some of the top "problem states" when dealing with nonresident withholding are: California, Colorado, Indiana, Iowa, and Kansas. These are just a few. As I stated earlier, in a multi-tiered structure, nonresident withholding is a "tracking nightmare" for both the taxpayer and the state. Obviously, it requires meticulous record keeping to get it right.
If you or your client operate within a multi-tiered, multi-state pass-through entity structure, please contact [email protected] to help you work through the "maze."