States may be jurisdictionally limited from collecting state income tax from nonresident owners of pass-through entities. As a result, states often rely on the pass-through entity ("PTE") itself to self-regulate and properly remit taxes due from nonresident owners.     

Most states fall into two categories of tax collection structures: withholding or composite. The withholding tax structure requires an entity to remit withholding tax on behalf of the owner. In most cases, the PTE will treat this as an owner distribution for accounting purposes, as it is not a deductible business expense. The individual owner is generally obligated to file its own return in the state, which can result in many tax returns being filed at the ownership level.

While it may sound simple to withhold tax on an owner's income, in reality the compliance may not be as straightforward. Some states have withholding thresholds, while the rate of withholding in other states can vary depending on the type of owner. In addition, withholding in itself may not be compulsory. For example, some states require withholding only on behalf of certain partners (i.e. individual partners), and some states only require withholding on S-corporations, but not partnerships or LLCs, or vice versa. Furthermore, while withholding may be purely voluntary at the option of the PTE or its owners, it may be advantageous for the PTE to withhold on behalf of their non-resident owners to avoid the need to pass sensitive income information to the owners for purposes of computing estimates. Although this can lead to over-withholding, it is often the simplest method when an owner's only in-state activity is the income from the pass-through entity.

On the other hand, there are some reasons why owners may not desire to have the PTE withhold on the owner's behalf. The most common reason is an owner has other activities in the state resulting in losses that can offset the PTE income. If the owner knows that ultimately no tax will be due, this can reduce cash outflows of the entity. Additionally, the owner may already be making estimated tax payments due to other activities, and withholding at the PTE level may result in duplicative payments. Finally, the PTE may prefer to file a composite return to avoid each owner from filing an individual return.

Moreover, one of the difficulties around withholding payments has nothing to do with state-imposed requirements, but rather with legal requirements surrounding the PTE itself; namely, S-Corporations must be cognizant of proportionality for tax distributions.

Decision-making around withholding compliance brings up more complexity than what may appear at the surface. Consequently, it is important to keep open lines of communication between businesses and practitioners to ensure that applicable taxes are paid timely and sufficiently to cover an owner's tax liability. Tiered entity structures bring extra layers of complexity to an already convoluted area, and businesses should be aware of the implications of their own withholding preferences in addition to each relevant state's statutory requirements.