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UPON FURTHER REVIEW, THE DECISION ON THE FIELD IS REVERSED

April 25, 2005

Iowa has reversed a March 21, 2005 policy letter that would have denied the credit for taxes paid in non-resident states to Iowans participating in "composite" returns.

Composite returns are filed by pass-through entities -- S corporations and partnerships -- to save owners the expense and hassle of filing non-resident returns in all states where the entity operates. The credit keeps taxpayers from doubling-up on state income taxes.

The Department got it wrong the first time, but it deserves credit for its prompt correction. We hope it becomes a habit. Mike Ralston, Director of the Department, was personally involved in the correction process.

The letter reversing the policy can be found here. The text of the supeseded letter has been removed from Iowa's site, but can be found in the extended entry below (click "read more"). Our post on the superseded letter is here.

Text of superseded letter:

March 21, 2005

The Department has reviewed your letter dated March 11, 2005 in which you requested clarification on whether the out-of-state tax credit would apply in situations where tax was paid in other states through the filing of a composite return.

Your client is an Iowa resident who owns a closely-held S corporation which is located in Iowa. The corporation does business in 10 or 12 other states and is required to file an S corporation return in these other states. For expediency and practical concerns, composite returns are filed on behalf of the shareholders of the S corporation in these other states so each shareholder is not required to file individual income tax returns in each of these states. In essence, the S corporation is paying the individual income tax in these other states on behalf of the shareholders.

You are asking whether the resident Iowa shareholders can claim the out-of-state tax credit on their Iowa individual income tax returns for their share of the taxes paid on a composite basis to other states.

Iowa Code Section 422.8(1) is the statutory authority for the out-of-state tax credit, and this reads in relevant part:

"The amount of income tax paid to another state or foreign country by a resident taxpayer of this state on income derived from sources outside of Iowa shall be allowed as a credit against the tax computed under this chapter, except that the credit shall not exceed what the amount of the Iowa tax would have been on the same income which was taxed by the other state or foreign country."

It is clear from this statute that an Iowa resident can claim the credit for taxes paid to another state only in the instance when the resident paid the income tax to another state. The Department contends that there must be specific statutory authority to allow income taxes paid on a composite basis in other states to be considered for the out-of-state tax credit. For example, the state of Missouri has the following provision regarding their out-of-state tax credit in section 143.081.3.

"For the purposes of this section, in the case of an S corporation, each resident S shareholder shall be considered to have paid a tax imposed on the shareholder in an amount equal to the shareholder's pro rata share of any net income tax paid by the S corporation to a state which does not measure the income of shareholders on an S corporation by reference to the income of the S corporation or where a composite return and composite payments are made in such state on behalf of the S shareholders by the S corporation."

Therefore, the Department contends that the Iowa resident shareholders cannot claim the out-of-state tax credit for taxes paid to other states by the S corporation through the composite return filing because there is no statutory authority in Iowa Code section 422.8(1) to allow the out-of-state tax credit in this situation.

If you have any questions on this matter, please contact me at (515) 281-6183.

Sincerely,

Jim McNulty

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