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IOWA SUPREMES: NONRESIDENT S CORPORATION SHAREHOLDERS NOT TAXED IN IOWA ON "NONBUSINESS" INCOME

June 26, 2003

Taxpayer Wayne lives in Idaho. He has an old savings account account in an Iowa bank. As an Iowa non-resident, he reports the interest income on his home state return, and not in Iowa.

Wayne puts the savings account in his wholly-owned Iowa S corporation, Thor, Inc. Thor's only other asset is an Iowa farm. Because Thor is an S corporation, Wayne pays tax on all of Thor's income on his 1040. Should Wayne start paying tax on the savings account income just because it is now in an S corporation?

We would have always said "no," but the Iowa Department of Revenue and Finance urged the Iowa Supreme Court to just say "yes." Fortunately, the Supreme Court earlier this month agreed with us.

COMACHO AND STANKEE.: LOSS FOR THE TAXPAYERS, BUT VICTORY FOR TAX POLICY

Jill Camacho lived in Wisconsin; her brother, Glen Stankee, lived in Florida. Both Jill and Glen owned small interests in an Clark Farms, Inc., an S corporation that owned farmland in Clinton County, Iowa. The S corporation earned some interest income in addition to the farm business income. Jill and Glen did not pay Iowa tax on the interest income shown on their Clark Farms K-1. The DORF said they should, and the case went to court.

The DORF argued that nonresidents should pay tax on all interest income of an Iowa-domiciled S corporation, whether or not the income is "business income." The taxpayers argued that they should not have to Iowa pay tax on the interest income because it was "non-business" income (among other arguments).

The Court ruled against the DORF on the law, holding that non-residents are not taxable in Iowa on their share of S corporation non-business income. The Court then ruled against the taxpayers on the facts, saying that they failed show that the interest was non-business income; as "business" income, it was taxable to Iowa along with the farm business income.

BUSINESS V. NON-BUSINESS INCOME

Iowa S corporations with non-resident shareholders should distinguish between "business" and "non-business" income in their investment portfolio. The distinction is fuzzy; the Court turned to Iowa's tax regulations, citing two examples as "particularly relevant":

EXAMPLE F – A nonresident has a farm in Iowa which is the nonresident’s principal business, although this person is an Illinois resident. The nonresident has an interest-bearing checking account in an Iowa bank. This checking account is used to pay personal expenditures as well as to pay expenses incurred in operation of the farm. In 1982, the taxpayer will earn $550 in interest from the checking account. The interest would be included in net income allocated to Iowa since the interest is derived from the business, generated from a business account, and utilized in the business.

The regulations tell us that extra funds should be moved to accounts not used in day-to-day business activity if the taxpayer wants the earnings on the funds to be treated as "non-business" income.

THEY MEANT WHAT THOSE FORMS SAID!

Iowa's K-1 for non-resident S corporation shareholders has always had an annoying feature: it allocates interest and dividend income to non-residents in the same way it allocates business income. We always assumed that was a result of lazy draftsmanship; after all, everybody knows that non-business income is taxable only in the resident state, right? But Camacho and Stankee shows that they actually meant what the forms said. Fortunately, the case also shows we properly ignored the form instructions! (whew.)

A REFUND OPPORTUNITY?

Iowa non-residents who have paid Iowa tax on their S corporation non-business income now should file refund claims on form IA-1040X. The statute of limitations for the refund claims is normally three years.

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