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Discussion:DC S-Corp Franchise Tax

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Discussion Forum Index --> Advanced Tax Questions --> DC S-Corp Franchise Tax


Discussion Forum Index --> Tax Questions --> DC S-Corp Franchise Tax

BestGuess (talk|edits) said:

28 August 2009
I have a new individual client who is a VA resident. She is the sole member of an S-corp that operates in DC & VA, business apportioned about 50/50 between the two. The S-corp paid a DC franchise tax of about $70,000 for 2008. Now when doing her personal return it looks like we have to pay VA income tax on all 100% of the income. And VA says we can't take credit for the Franchise tax paid because it is not an income tax. So the DC portion of the income is taxed twice, once in DC by the Franchise tax and again in VA. Is there some way to avoid this? The VA K-1 has an apportionment factor of 50% but since there is reciprocity with DC and no DC return to file as an individual I think we have to report all income on the VA return. Any advice?

Harry Boscoe (talk|edits) said:

28 August 2009
Good Golly! This sounds exactly like what I ran into about 25 years ago. Haven't they [who are "they" in this case? Not my problem.] resolved this clearly unjust result yet?

TRcpa (talk|edits) said:

28 August 2009
What type of business is the S-Corp? There are some special rules for professional and exemptions that maybe available on the DC side. Otherwise I say kill the S election since DC does not recognize it.

KatieJ (talk|edits) said:

28 August 2009
Unfortunately the DC franchise tax applies not only to C corporations and S corporations but also to most unincorporated businesses, and the Virginia statute clearly excludes any franchise tax or unincorporated business tax from taxes eligible for the other state tax credit against a resident individual's VA tax liability. You can't avoid the double tax by terminating the corporate/S election and electing partnership treatment, because a partnership is also subject to the tax.

The validity of the unincorporated business tax imposition on nonresident individuals has been challenged in the courts, because the Home Rule Act prohibits the District from taxing nonresident individuals on a source basis. However, the District Court of Appeals held that the imposition of the tax against a partnership of real estate professionals did not violate the Home Rule Act, and the U.S. Supreme Court denied certiorari. D.C. v. Bender, et al, D.C. Court of Appeals, Dkt. Nos. 06-TX-255 & 06-TX-294, 08/24/2006; cert. denied U.S. Sup. Ct., Dkt. No. 06-719, 02/20/2007; rev'g Bender et al. v. D.C., D.C. Super. Ct. (Tax Div.), Dkt. No. 8524-05, 03/08/2006.

Unincorporated businesses that are not subject to the tax (D.C. Code Ann. §47-1808.01) are:

   (1) any trade or business that by law, customs, or ethics can not be incorporated; 
   (2) any trade, business, or profession that can be incorporated only under the D.C. Professional Corporation Act; 
   (3) any trade or business in which more than 80% of the gross income is derived from the personal services actually rendered by the individuals or the members of the partnership or other entity in conducting or carrying on the trade or business, and in which capital is not a material income-producing factor; or 
   (4) any trade or business engaged in by a blind person licensed by the District under the act authorizing blind persons to operate stands in federal buildings (20 U.S.C. §107).

If the OP's client's business falls into one of those categories, terminating the corporate/S election and reverting to partnership status would avoid the entity-level DC tax. Otherwise you are stuck with it. Virginia taxes all income of residents, regardless of source, and by statute allows no credit for a franchise tax or unincorporated business tax.

One solution to the problem would be for the client to move to Maryland, which does allow credit for income-based taxes (no matter what they're called) paid to jurisdictions that don't recognize S corporation status. Md. Code Ann. Tax-Gen. §10-703(c). Maryland also allows credit for the DC unincorporated business tax. See the Form 502CR Instructions.

Notax (talk|edits) said:

28 August 2009
Don't know about killing the S election. Seems like there may be some federal benefit of a single layer of tax on 1.4 million of taxable income. How about advising your client to relocate their residence to DC? Seems like living in Virginia costs your client roughly 40K per year.

BestGuess (talk|edits) said:

28 August 2009
All this feedback is great. Unfortunately it sounds like moving to MD or DC is our only solution. Reverting to C Corp sounds like it would ultimately be more costly. The business is incorporated in VA, so I don't think we can qualify as an unincorporated business that would not be subject to the DC tax. The business is fundraising. Even if we reformed the entity as an LLC I don't think we could meet the exceptions above in KatieJ's comments, regarding (1)obviously have already been incorporated so don't meet this; (2) don't know about this one; (3) aside from my client, the payroll for the rest of the staff is about $1M, so I don't think we could ever say my client accounts for 80% of the gross income; (4)my client isn't blind. I've tried to get her to move the business out of DC, but she says she needs to be there to be recognized in her field.

BestGuess (talk|edits) said:

28 August 2009
Another idea. Right now she takes about $100,000 W-2 salary and $1M+ in distributions. This leaves the $1M+ on the books as net income which is what creates the DC Franchise tax. What if she takes all the net income as W-2 salary? That would leave net income zero. Would this fly with DC? She is taking all the money out anyway. Why not take it as salary? She would get hit with Medicare tax at 2.9%, but this is better than DC Franchise tax at 9.975%

Taxman3132 (talk|edits) said:

28 August 2009
cant your reduce the amount earned in dc on the virginia 502? i thought that there was a subtraction for that. now i have to go look--i did it on a 2007 s corp

KatieJ (talk|edits) said:

28 August 2009
The only income adjustment I see in the VA law is for S corporation income that is subject to the VA bank franchise tax. Va. Code Ann. §58.1-322(G).

See the Form 502 instructions, page 2: "• a Virginia resident individual owner is taxable on all of his or her pass-through entity income regardless of the entity’s apportionment."

Harry Boscoe (talk|edits) said:

29 August 2009
IIRC, the compensation deduction on Form D-30 is limited to some percentage of something so that completely "zeroing out" the DC tax return is not going to happen...

KatieJ (talk|edits) said:

29 August 2009
Maybe not, but you could certainly minimize the DC corporate level tax by maximizing the salary. The beauty part is that DC can't tax the wages earned by the nonresident stockholder/employee from services performed in the District. I'd expect the District would likely challenge an excessive level of compensation. You'd want to have comparable salaries in the industry, records of undercompensation of the sh/emp in prior years, etc. to back up your position.

Harry Boscoe (talk|edits) said:

29 August 2009
Actually, there's a 30%-of-net-income-before-owners'-compensation limitation on deductible salaries and other compensation to owners on DC's Form D-30 written into the law and it pretty much relieves DC of having to challenge owners' comp as being excessive. The DC statute mechanically caps the deduction at 30% of net income. But yes, pay a bigger salary, and after the Medicare levy you're maybe still way ahead if it skirts the double taxation.

And as for actually moving to DC or MD, Virginia's income tax is only 5.75% while Maryland is about 8% and DC is even higher, I think. The move would get around the double state level taxation of the business profits but personally I can't imagine anyone leaving the Commonwealth for a few thousand dollars of state tax. But on the other hand the tax savings would be an annuity - it would keep on going year after year, as long as the business keeps cooking at the rate it's going now.

I'll bet a lot of people wish they had your client's tax problems...

Taocpa (talk|edits) said:

29 August 2009
KatieJ is absolutely correct.

I get my clients (if I can) out of DC. They tax just about everything and its bureaucracy is a nightmare.

DC doesn't recognize S Corps, hence what KatieJ refers to above is on target. So, you wind up recognizing all the income in VA.

DC's tax rate is 10%. Harry is correct that MD is 8% and VA is 5.75%. Basically, as Harry points out, you have to "pick your poison" as they say.

Tom

Harry Boscoe (talk|edits) said:

29 August 2009
Does DC's three-factor apportionment formula allow any flexibility? It's been *decades* since I did this stuff, but there used to be some different factors, like "one-factor" for services, that could be used, that legitimately allowed a multi-state business to move its taxable income, just a little bit, from a worse state to a better state. For the kind of $ your client is paying in state taxes, this deserves careful investigation.

I have forgotten more than I ever knew about the strategy and tactics of multi-factor multi-state income apportionment...

KatieJ (talk|edits) said:

30 August 2009
Harry, thanks for the reference to the 30% rule, I'd missed that. D.C. Code Ann. §47-1803.03(a)(11); D.C. Mun. Regs. 104. However, it only applies to unincorporated businesses, not to corporations. So BestGuess's client would still have to defend, potentially, against an assertion of excessive compensation by DC -- but wouldn't be limited to 30% of net income.

DC at one time allowed a single factor of sales as an alternate to the equally-weighted three-factor formula, but it was in a regulation which the U.S. Supreme Court held was not in accordance with the statute. General Motors v. D.C. (1965), 380 US 553. The only special formulas I found are for financial institutions and transportation companies. DC does have an equitable apportionment statute similar to UDITPA Sec. 18, but the burden is generally on the party that wants to use something other than the standard formula to show that it does not fairly represent the extent of the taxpayer's activity in the state. That's especially hard to do with an equally-weighted 3-factor formula, because no matter how distortive one of the factors may be, the other two may tend to balance it out.

Harry Boscoe (talk|edits) said:

30 August 2009
Does an S corporation file a D-20 or a D-30 in DC?

Have I totally lost it? Don't answer that...!

Taocpa (talk|edits) said:

30 August 2009
S Corps file a D-20 in DC. Therefore, no flow-through.

Unincorporated businesses file a D-30.

It's still a 3 factor test; property, payroll and sales. It's weighted between all 3, if you have all 3. If you have 2, it's weighted between 2.

Basically, sounds like a move to MD is the best bet since it's cheaper. DC's taxes and bureaucracy is a true nightmare. Remember, this is the same city that elected convicted felon and now tax dodger Marion Barry mayor twice. He still sits on the city council.

I have a client right now who is jumping on my head over the fact he owes DC franchise tax on his little restaurant. Well, he made too much money, that was his first problem.

Tom

BestGuess (talk|edits) said:

30 August 2009
Thanks again for great feedback. I think we have stretched to the limit on apportionment so I don't think we can go any further with that. I was afraid of the excessive compensation issue. It does sound like bumping up the salary to a more reasonable level would help, as long as we don't go too far. And it is helpful to know that DC applies a 30% of net income limit in other situations. Even if it doesn't apply specifically to incorporated businesses it sounds like a good reference point. If we bump the salary from $100000 to $400000 we can probably save $10000 after the Medicare tax and apportionment. I think that is a step in the right direction and easier to accomplish than a move to MD. You are right, an income over $1M is definitely a good problem to have. I just wanted to make sure I wasn't missing an easy fix to her problem and you all have made it clear it is a sticky problem with no easy answers. Thanks so much.

Harry Boscoe (talk|edits) said:

30 August 2009
Sorry for the distracting tangential and erroneous BS I inserted about the 30% limit that *doesn't* apply to S corporation owner compensation! You made it sound almost like it's helping you, BestGuess!

Take a big piece of that officer compensation as *rental* and avoid the Medicare bite...

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