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IOWA DEPARTMENT OF REVENUE GETS IT WRONG AGAIN

April 11, 2005

Pass-through entities - S corporations, LLCs and other partnership vehicles - have become increasingly popular in the tax world. The income of these entities is taxed on their owners returns, avoiding an additional layer of corporate tax. Now Iowa wants to add it's own second layer of tax for many pass-throughs.

One drawback of these entities is that when the entity files in many states, the individual owner is also taxed in those states. This can result in dozens of state tax returns for each owner. Most states alleviate this problem by permitting "composite" returns, allowing the corporation to file a group 1040 on behalf of non-resident shareholders.

All states that impose an income tax allow a credit for taxes paid to other states to prevent the doubling-up of state taxes. In general, if you pay a tax to a non-resident state, you reduce your resident tax by the the non-resident state tax (but by no more than the home state tax computed on the income taxed by the other state).

Today the Iowa Department of Revenue issued a "policy letter" saying that taxes paid on composite returns don't qualify as taxes for the non-resident credit. In a crabbed and shortsighted interpretation, the Department said that because the tax is paid "on behalf" of a taxpayer on a composite return, rather than "by" the taxpayer, it doesn't qualify for the credit.

This is silly. Many states require corporations to "withhold" tax on non-resident pass-through owners. Is Iowa next going to say this doesn't qualify because it's not paid "by" the shareholder?

Under this policy, the department forces pass-through owners to choose between paying perhaps thousands of dollars to file in multiple states, or allowing Iowa to subject their income to an unauthorized second state tax.

That will do a lot for economic development.

Belated thanks to ever-alert George Davis for the tip.

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