If you’re an investor in a pass-through entity that does business in several states, you likely have two options for filing taxes. The first option is to file an individual state income tax return based on the K1 received from the entity’s filing in each state. The second option is to file a composite return, which negates the need to file a state individual tax return. While the latter might save time, it could end up costing you more money.
Composite return overview
Simply stated, a composite return is filed by a pass-through entity and reports the state income of all non-resident owners as one group. If a non-resident owner participates in a composite return, that non-resident is not required to file an individual income tax return.
At first blush, the composite return option seems like a good deal. From an administrative standpoint, it’s easier to file one return based on the aggregate of all investors’ pass-through income sourced to a state rather than filing individual returns for all investors in a pass-through entity. But you may be paying for that convenience. Following are some situations to be aware of:
Participating in a composite return may subject you to higher taxes than if you file an individual return. For example, Ohio offers a preferential income tax rate on business income and the Ohio business income deduction, but taxpayers that forego filing an Ohio IT1040 personal income tax return miss out on these tax breaks, as the composite filing option does not offer them.
Also, state individual returns are based on overall federal adjusted gross income, which may include deductions and/or losses not available at the composite level. And other states will typically tax composite filings at the highest marginal rate and might disallow credits and filing options that are available at the individual level.
Furthermore, if an individual has independent sources of income from a particular state in addition to distributive share of state-sourced pass-through income, many states would prohibit participation in a composite filing.
You could be vulnerable to an open statute of limitations if a personal return is not filed. Said another way, filing a composite return only starts the statute for the composite return and associated pass-through entity income reported. If you have independent sources of income and fail to file an individual return, the statute timeline never starts, and you could be subject to tax, penalties and interest down the road.
Composite returns are convenient and administratively easier, but they’re not always the best answer. An experienced state and local tax advisor can help you make the right decision.