S Corporations and State Income Taxes

calendar iconMay 16, 2023

John Ford | Senior Consultant, Government Contracting Industry Practice
Tony Konkol | Manager, State & Local Tax Practice

As a general rule, corporations are responsible for paying Federal and state taxes on the income they earn. This is not necessarily the case for smaller entities that qualify for special treatment under the Federal Internal Revenue Code for S corporations. S corporations are corporations that elect to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income.

The election to become an S corporation is evidenced by the owner(s) filing Internal Revenue Service (IRS) Form 2553, which must be signed by all the owners of the company. Similarly, many states have passed laws that allow an S corporation to avoid paying state income taxes on the income of the company, but permit the owners to report such income on their personal state tax returns. There is a growing trend whereby the states are now allowing companies to pay the state taxes associated with the business for the shareholders.

These optional elective entity-level income tax regimes for pass-through entities (PTEs), such as S corporations, have been enacted by more than 30 states in response to the Tax Cuts and Jobs Act’s (TCJA) $10,000 state and local tax (SALT)-cap that is imposed on individual taxpayers. Because the TCJA’s SALT-cap does not apply to business entities, some measure of relief is provided to owners of PTEs by these optional entity-level state income taxes due to the PTEs ability to deduct them for federal income tax purposes.

Since individual owners of PTEs report their proportionate share of business income on their individual income tax returns, these entity-level tax workarounds shift state income taxes on PTE income from the individual owner back to the PTE itself. Although state pass-through entity tax (PTET) elections are generally sector agnostic, there have been specific considerations and complexities in the government contracting sector, where the question has been raised as to whether contractors that pay these taxes can claim the taxes as an allowable cost for purposes of government contracting.

Analyzing Federal Regulations

Federal Acquisition Regulation (FAR) 31.205-41, Taxes, states in part “The following types of costs are allowable:

(1) Federal, State, and local taxes, except as otherwise provided in paragraph (b) below that are required to be and are paid or accrued in accordance with generally accepted accounting principles.” Paragraph (b) states that Federal income taxes are not allowable but does not mention state income taxes. Therefore, state income taxes are generally an allowable cost. In Information Systems and Networks, Inc. v. U.S., 48 Fed. Cl. 265 (USFC, 2000) (ISN I), the Court of Federal Claims had to address how this cost principle applied to S corporations.

In ISN I, the contractor was an S corporation located in Maryland. ISN claimed state income taxes paid by its sole shareholder on the income of ISN in its general and administrative pool. As justification as to why this cost was allowable, ISN asserted it had a sole shareholder, and therefore the entire income tax liability of ISN passed through to the shareholder’s personal income tax liability.

ISN alleged that it and the shareholder entered into an agreement where ISN would reimburse the shareholder for taxes paid on the income of ISN. In accordance with the agreement, the shareholder paid the state income taxes incurred by ISN on her own income tax returns but had been reimbursed by ISN for the payment of those taxes. The Defense Contract Audit Agency (DCAA) questioned these costs, asserting that they were “a personal tax expense to the shareholders. The state income taxes of individuals are not allocable to the company.”

The Administrative Contracting Officer (ACO) agreed with DCAA and disallowed the costs. However, the U.S. Court of Federal Claims (COFC) agreed with ISN and held that the costs ISN had incurred in reimbursing the shareholder were allowable costs.

The government appealed this decision to the Court of Appeals for the Federal Circuit. In Information Systems and Networks, Inc. v. U.S., 437 F.3d 1173 (2006) (ISN II), the Federal Circuit reversed the COFC’s decision. In doing so, the Court stated,

the Court of Federal Claims also held that “the state income taxes were required to be paid and were paid,” and therefore the costs claimed by ISN were allowable under [FAR 31.205-41(a)]. . . . But this inference is also incorrect. The allowable, taxes described in [FAR 31.205-41(a)] apply to taxes paid by the contracting entity. As an S corporation, ISN never paid any state income taxes. Only Ms. Malkani paid state income taxes on dividends paid to her from ISN. Because she is not the contracting entity, [FAR 31.205-41] is inapplicable to Ms. Malkani’s state income tax payments.

The Court went on to say,

The plain language of [FAR 31.205-41(b)] states that taxes from which the contracting entity is exempt are not allowable costs. This is the case here. ISN is free from taxation on Ms. Malkani’s income derived from ISN’s corporate dividends. Therefore, in its cost-reimbursement contract, Ms. Malkani’s state income tax payments themselves cannot be an allowable cost for ISN.

State Implications of Federal Rulings

From ISN II, it was established that for a contractor to claim a tax cost in accordance with FAR 31.205-41(a), the contractor must be obligated to pay the tax and must have actually paid the tax. This is nothing more than an application of the principle that a contractor cannot claim a cost that it did not actually incur.

Applying the lesson of ISN II, in determining whether taxes an entity pays on behalf of its shareholders is an allowable cost, it must be determined whether the contractor is required to pay the tax or if paying the tax is merely an option for the contractor. If the former situation is present, the contractor should be able to claim the tax as an allowable cost once it has paid the tax. If the contractor is not required to pay the tax, but only has the option of paying it, then such cost would likely not be an allowable cost.

Connecticut was the first state to pass an entity-level PTET in May of 2018, which is a mandatory entity-level tax on PTEs (and remains the only state to mandate an entity-level income tax on PTEs). Since then, every other state that followed in enacting a PTET has enacted legislation that would allow the entity-level PTET to be an optional election. With that in mind, a state PTET election may not recharacterize an otherwise non-allowable cost to an allowable one. However, the owners of a PTE could possibly be in a more favorable situation by making a PTET election than without one, due to the sector-agnostic federal deduction of state income taxes for a taxpayer that otherwise would not be available in the absence of a PTET “SALT-cap workaround.”

The SALT-cap is currently set to expire at the end of 2025, making this a temporary situation—at least for now. Given that the SALT-cap is helping to generate revenue at the federal level, it may be extended in some shape or form beyond 2025.

To learn more about the advantages of PTET elections, reach out to a member of our Government Contractor Industry or State & Local Tax team for more guidance.

Questions? Contact Us