Iowa financial institutions must file an Iowa franchise tax return (Form IA 1120F) that taxes the net income apportionable to Iowa at a flat rate of 5%. Double taxation on Federal taxable income is avoided when the individual shareholders report their own pro-rata share of income on their Form 1040 and are taxed on that income. What about Iowa? Iowa appears to be taxing the income or loss from the holding company just once, but isn't the income from the subsidiaries being taxed twice? The answer is both yes and no: yes for non-Iowa shareholders, but no for most Iowa shareholders.
The same income, more or less (see below), is reported on both the individual's IA Form 1040 and the bank's Form IA 1120F. However, Iowa resident shareholders receive a credit for the pro-rata portion of the franchise tax paid by the bank on the same income. This credit usually eliminates a resident’s Iowa tax liability from the S corporation bank K-1 as modified for Iowa taxation, and it may also offset tax liability created by the shareholder's other Iowa source income.
The credit system works less well for non-Iowa shareholders. While their Iowa credit will eliminate their Iowa tax, they are usually fully taxable on their K-1 income in their home state. As a result, their share of the bank’s income is subject to both the franchise tax and state personal income tax.
What are the differences between Federal and state K-1 income? While state taxable income is based on the Federal computation, there are important differences.
Federal ordinary income as reported on Schedule K-1 normally includes Federal interest and dividends, which are exempt from state incomes taxes; a shareholder’s Iowa taxable income is adjusted to exclude the exempt amount.
The Federal Schedule K-1 ordinary income for tax years ending after September 10, 2001 and before December 31, 2004 will also likely contain "bonus" depreciation expense for Federal income tax purposes. This "bonus" depreciation is not allowable for state purposes. Shareholders must adjust their taxable income to reflect the difference between Federal and Iowa depreciation.
Municipal income that is exempt for Federal purposes, other than “double-exempt” bond income, must be added back to Form IA1040.
Other adjustments may apply that cause Federal and Iowa income to differ. These differences generally are reported to shareholders with their K-1 information.