What is a Composite Tax Return?

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Some taxpayers invest in a pass-through entity that operates in multiple states. They may owe state income taxes in states other than where they reside, which can be complicated and time-consuming. Many states allow filing a composite return that reports the individual state earnings of every investor.

What is a Pass-through Entity?

A pass-through entity is a business structure that passes income to the owners or investors, who then report it on individual tax returns, so the entity itself is not taxed.

Most American businesses (sole proprietorship, partnership, S-corporation, or limited liability company) qualify as pass-through entities if the income is reported by the owners’ tax returns instead of being taxed at the corporate level.

Depending on the ownership percentage, earnings are allocated among the owners. Each owner is taxed on their share according to their tax rate.

Here is an example: Imagine yourself as a partner in a company of three. If the partnership’s net income is $300,000, each partner will pay their share of taxes on $100,000.

Note: The partners still need to pay taxes on the income they were to receive if the partnership chooses to reinvest the profits in additional holdings.

Since a pass-through entity does not pay corporate taxes, it can save significantly on taxes, unlike other structures. However, remember that not all states allow composite returns.

  • Arizona, New York, and Vermont decide which companies may file composite returns.
  • Utah, Oklahoma, Nebraska, and Tennessee do not allow this method.
  • Florida, Texas, and a few other states do not require filing as they have no personal income tax.

What Are the Benefits of Composite Tax?

Composite tax is convenient for owners of pass-through entities. Since it is a combined return, it covers the state tax obligations of all owners or those who want to participate. If you’re one of them, you are not responsible for filing individual returns in different states. The overall paperwork reduction can also mean lower tax preparation fees.

Note: Composite filing may not always be financially beneficial for every owner because they may either pay higher marginal tax rates or skip potential state deductions.

Should You Participate in a Composite Filing?

  • An owner with other income in the individual state may opt out of a composite filing.
  • While unlikely, there may be cases where an owner’s resident/nonresident status in a particular state is a reason for dispute. They may choose to leave themselves out of a composite filing. It gives them more time to resolve potential problems without penalties.
  • If the company does not see profit, the owners can choose to go without this method, as previous losses cannot be addressed using composite filing.

Ultimately, company owners must consider the merits and demerits of a composite filing and understand the impact of their decision. If things seem complicated, they can consult a professional for expert advice.

Summary: Learn what composite filing is, its benefits, whether your company should use composite filing, and more with Jarrar CPA.