Composite Return for Your Law Firm- Should You Participate?
One of the top questions we get from lawyers is if they should elect to file a composite tax return. For a law firm that practices in more than one state, partners will have income tax liabilities and filing requirements wherever the firm establishes a nexus. This complicates their personal returns, as each state has different complex tax laws, driving up tax preparation costs. Some states allow a pass through entity to file a return on behalf of its owners, reporting each owner’s share of state income. A composite return filed by the firm consolidates qualifying nonresident partners into one return, if they elect to do so.
A partner is eligible to elect to file with his firm’s composite return if he is a nonresident in a given state for the entire year, and if he has no other income in that state. However, some states allow more than one composite filing if a partner has multiple K-1’s from such a state. The election is done on a state by state basis; a partner may elect in and out of each individual one. One may receive a tax deduction on Schedule A of his personal tax return for state taxes filed on his behalf by his company.
While participating in a composite return might seem like the obvious choice, there are some disadvantages to doing so. Most states tax the participating individuals at the highest personal income rate, which may be higher than the individual’s income tax rate had he been filing alone. Additionally, if one elects to file a composite return, he forfeits certain deductions, exemptions, and credits that would have been allowed on a personal return. Another disadvantage is that losses can’t be carried forward on composite returns, while they can on individual returns. It is important to consult with a tax advisor to determine if the tax preparation savings gained from opting into a composite return outweigh the benefits of filing separately. Another important point to keep in mind is that there is no statute of limitations regarding a composite return. For example, if a state later discovers other income that should have been reported in that state, the composite year remains open for assessment.
There are some specific issues that come up for S-Corporations filing composite returns. As an S-Corp, partners must receive distributions pro-rata, which means according to their ownership percentage. This often complicates matters when firms file composite returns and make payments accordingly. If, for example, nonresidents are taxed at higher rates than residents or nonparticipating members, they will often receive larger distributions in order to satisfy their larger tax liability. Companies who do so should institute annual corrective distributions so as not to jeopardize their S-Corp status.
Firms that operate in more than one state often elect to file composite returns, in order to simplify tax preparation and minimize preparation costs. The election to participate in a firm’s composite return can be made by each partner, for each state. Although it seems simple to participate, one should first consult with a tax advisor to analyze the relevant issues and determine which decision will be the most beneficial.