Discussion:S-Corp separately stated items

I haven't seen this done before, but I recently saw old corporate returns for a new client where this was done. I researched it, and found that the Regs. state that ANY item must be separately stated if, by stating the item, the shareholder's tax liability would be affected.

Since state taxes could affect the computation of a shareholder's AMT, is this saying that state taxes should be separately stated? Doesn't sound right to me.

For my LLC situation, BNA, book 725-2nd, pages A-76 & A-77 implies the same thing. Ky in 2005 treats LLC's as corporations. The Ky accrued income taxes should be deductible on the LLC's return (accrual basis used). Does anybody see a different treatment? Thanks...

Quoting directly from Revenue Ruling 81-288, “……..The intent of Congress was that state income taxes, imposed generally, would not be deductible under section 62 of the Code merely because the net income arose from a business, but that taxes of any kind that are imposed only on business activity, or business property, or business income, would be deductible……” To paraphrase RR 81-288, a tax that is imposed solely on business income, property, or activities may be deducted in arriving at AGI, but that state income taxes that are imposed generally would never be deductible in arriving at AGI. Thus, in the example cited in RR 88-288, the New Hampshire Business Profits tax was a tax that was imposed solely on business profits (after subtracting a reasonable allowance for the proprietor’s salary), and the Service ruled that such a tax should be deducted in arriving at AGI.

I don’t believe that there any basis in law for PPC’s suggestion that the taxpayer may apportion the business portion of the state corporate tax burden and deduct it as a cost of the S Corporation’s operations. In fact, this approach was specifically rejected by the Tax Court in Tanner v. Commissioner (45 TC, 145). The Tanner court observed that “…..the committee reports unmistakably reflect the intention of Congress that State taxes on net income, even though such income is derived from a trade or business, are not to be considered as deductions which "are attributable to a trade or business carried on by the taxpayer……."

Finally, Regulation 1.62-1T(d) states, “(f)or example, taxes are deductible in arriving at adjusted gross income only if they constitute expenditures directly attributable to a trade or business or to property from which rents or royalties are derived. Thus, property taxes paid or incurred on real property used in a trade or business are deductible, but state taxes on net income are not deductible even though the taxpayer's income is derived from the conduct of a trade or business”.

Riley2-Thanks for the your time and comments. I mostly agree with your last comments. However, Tanner v. Commissioner and just about all of the other cites I have found deal with state income taxes on the individual level trying to be deducted somewhere other than on Sch A. With Tanner, the taxpayer tried to allocate the portion of his individual state income taxes to page 2 of Sch E that related to his partnership income on Sch E. There are no partnership level state income taxes with Tanner.

The question here is what happens when the state income taxes are at the entity level and not at the individual level and the state treats the entity as a C corporation and the Feds treat it as a pass-through?

If Riley2 is correct, with my LLC which has computed the state income taxes on the accrual basis, should I convert the separately stated income tax items on the K-1's to cash basis? Oh what fun we are having!

Nuts and Bolts-KY LLC return shows an addition to income for "state income taxes" deducted in arriving at net income. Does this imply Ky Dept of Rev believes that with a LLC, state income taxes are deductible at the LLC level and not separately reported? (More fun: KY-single-member LLC's are taxed as C Corporations.)

Other items - The CPA Journal put out by NYSSCPA has an article dated August 1989, The state trap for S corporations by Antognini, Walter G. states, "State income taxes paid by S Corporations are deductible by the S Corporation in arriving at the corporate income to be passed through to the shareholders at the federal level." This only applies to S corps that are taxed as C corps. For more fun with single-member LLC's, look at Arthur Anderson, LLP, New York State Department of Taxation and Finance TSB-A-99(7). NY ruled that single-member LLC was a patnership for sales and use tax but a disregarded entity for income tax.

"The Department's understanding is that the tax expense is a deduction in arriving at ordinary income or loss at the entity level. The reason for the add back on schedule OI of the Kentucky return is that although the tax paid is allowed as a deduction at the federal level, Kentucky Revised Statute 141.010(13)(a) requires it to be added back in computing Kentucky net income.

The tax expense should be allowed as a deduction in determining federal ordinary income but state taxes based on gross or net income are not deductible for state purposes."

If you have any questions for Mr. Fackler, his phone number is 502-564-8139 ext 4737.

For what it is worth, we had a big 4 look at various tax issues with the KY LLC mentioned above. We specifically asked them to look at the treatment of the KY state income tax on the Federal return. They signed off on it being an entity level deduction at the Federal level with it being a KY LLC.