Law firm partners, consulting firm partners with K-1’s Out-of-State Tax Credits: (often prepared incorrectly), sometimes the missed tax credits are $10,000 or more per year
With many states becoming more sensitive to income tax filing requirements and enforcement, more national law firm partners and consults are receiving k-1’s with out-of-state tax that is owed or has been paid by the respective employers. Taxpayers with these k-1’s are finding that they need to pay income tax in multiple states that they did not file in prior years, leading to many tax implications.
One critical consideration is claiming out-of-state tax credits on your resident tax return. If you are required to file and pay income taxes in multiple states, you may be eligible for an income tax credit in your resident state for the tax paid to the nonresident state or states. Many states provide these credits so that taxpayers do not have to pay taxes to multiple states on the same line of income. Certain states also extend the availability of these credits to city and local taxes.
If you pay income tax in multiple states or localities such as New York City or Philadelphia, state and local tax credits may be available. Don’t overlook these opportunities for tax savings.
Filing Nonresident Composite Returns to Avoid Multistate Tax Returns
Many states offer businesses the option of filing nonresident composite returns on behalf of the owners. When a nonresident composite return is filed or elected by the business, the owner’s individual nonresident tax owed is paid by the business on behalf of the owners, which then, in turn, allows the owners to avoid the requirement to file a nonresident individual tax return in those states. Despite the owner not filing a nonresident individual tax return, the nonresident taxes paid on the composite returns are still available for out-of-state tax credits on the resident return.
Pass-Through Tax Entity Elections as an Alternative
Certain states have also begun offering PTE (pass-through tax entity) elections for income allocated to the respective state. These elections allow businesses to pay taxes owed to the state at the business level rather than have it flow-through and paid at the individual or composite level.
The key advantage to this is that it allows the business to deduct those state taxes paid against its federal business income. Essentially, it provides a way for states to circumvent the $10,000 cap on the SALT (state and local tax) deduction on owners’ individual returns.
However, the state taxes paid are not deductible on the state business returns and must be added back. It is important to note, though, that those state taxes paid under PTE elections to the owners’ nonresident states are also eligible for out-of-state credits on their resident returns.
What if My Nonresident and Resident State Do Not Have Tax Agreements?
There are rare cases where some states do not have reciprocal agreements with other states (for example: Virginia and California). Not having these agreements means if you’re a resident of one of these states, and you must pay nonresident tax to the other state, you would be unable to claim an out-of-state tax credit on your resident return for taxes paid to the nonresident state.
In today’s economic climate countless professional businesses (law firms, consulting firms in particular) file and pay significant income tax in a multitude of states. With this in mind, it is crucial that not only taxpayers, but also tax preparers understand these K-1 out-of-state tax credits to avoid unnecessarily paying thousands of dollars of tax on the same line of income to multiple states.
If you believe you were eligible to claim the out-of-state credits in prior years, but unknowingly omitted from your resident state tax return, there may be an opportunity to amend your prior year resident state tax returns to claim these out-of-state credits. If you may qualify for out-of-state tax credits and want to take advantage of them, contact us by clicking below.
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About Mike Wetmore
Partner, Co-founder, & CPA
Michael co-founded Ryan & Wetmore PC in 1988. Through his leadership and dedication, the firm has grown from a 2 person firm to a 3 office, 45 person firm serving the Mid-Atlantic region. Michael currently works with clients concerning individual, corporate, partnerships, and estate tax planning and preparation.
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About Andrew Snigur
Andrew is a Supervisor in our Bethesda, MD office. He joined the firm in 2014, and since then has worked with clients on a variety of complex tax issues. He obtained both his bachelor’s and master’s degrees in accounting from American University.
About Jason Dudas
Director & CPA
Jason is a Senior Manager in our Vienna, VA office. Since joining the firm in 2009, he has worked closely with clients on tax, audit and accounting issues. Jason has become an expert in construction accounting and is a member of the Real Estate and Construction CPA’s. He also has experience with research and development credits, and tangible property regulations.
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