For multistate S corporations, some level of double taxation usually exists. The ability of the corporation and its shareholders to avoid double taxation depends upon the states in which the corporation is doing business and the states in which the shareholders reside. If an S corporation does business in a state that does not recognize the S election and its shareholders reside in a state that does, then the corporation is taxed at the former state's corporate rates and the shareholders are also taxed at the latter state's individual rates. A shareholder who resides in a state that does not recognize S corporations is subject to tax on dividends received from S corporations. This shareholder will also be subject to tax in states recognizing the S election, for his apportioned share of S corporation earnings. In addition, since each state's allocation and apportionment statutes must be applied to ascertain the portion of the corporation's income attributable to the state, variations in apportionment formulas among the states may subject the corporation's shareholders to an income tax on more than 100% of the S corporation's income.

To mitigate the double taxation that may result, most states permit residents to claim a credit that is based on taxes paid to other states. The availability of this credit often depends upon who paid the taxes, the type of tax paid, or the source of the income generating the tax. For example, some states will permit shareholders to claim a credit for taxes paid by the S corporation to nonconforming states, while others will not.

Many corporations make the S election for federal purposes so that shareholders can utilize anticipated losses currently. If a shareholder's state of residence recognizes S elections, the passthrough of losses is equally beneficial at the state level. If a state's corporate tax rate is higher than its individual tax rate, the rate differential is often an advantage of making an S election. The effect of the rate differences, however, may be exactly the opposite for loss corporations.

In states that have graduated tax rates, the impact of rate differences will depend on the corporation and its shareholders. Nonresident shareholders can benefit from graduated rates when the state bases its tax rate exclusively on the amount of income derived by the shareholder from the state. The impact of other state provisions must also be considered in assessing the effective tax rates for corporations and individuals.

The Cost of Compliance

Corporate and individual compliance requirements are another issue that must be considered. For example, assume that an S corporation with 25 shareholders is subject to income tax in 20 states. If it were a C corporation, it would have to file 20 corporate income tax returns. For an S corporation, however, in addition to the corporate returns, the 25 shareholders would also have to file returns in each of the 20 states, potentially resulting in the filing of 520 state tax returns. Thus, it is not difficult to envision the compliance problems associated with an S corporation election. Some states allow the filing of multi- shareholder returns but, once again, there are as many different procedures and consequences of filing these returns as there are states that permit their filing.

Since each state has its own law, regulations, methods, and judicial interpretations, it is extremely difficult to quantify the state tax consequences of a federal S corporation election by a corporation doing business in more than a few states. However, with careful planning, this non-uniformity of state income tax provisions provides a multitude of opportunities that may allow a multistate S corporation and its shareholders to legally reduce their overall state tax liabilities.