On Tuesday, May 15, Governor Robert Bentley signed Act 2012-427 (HB 286) into law. This landmark legislation provides certainty regarding how to apportion income earned by a multistate pass-through entity (such as a partnership, an LLC electing partnership tax status, or an S corporation). In addition, the Act will provide Alabama resident owners with income tax credits for certain types of taxes the entity paid on their behalf to other states on its non-Alabama source income. As discussed below, portions of this Act are retroactive to tax years beginning after December 31, 2010, so amended returns may be necessary.
Summary of Previous Tax Treatment
By statute, “gross income” of an Alabama resident includes income from sources within and outside of Alabama. However, under the ADOR’s so-called “Gross Income Regulation,” income earned by a pass-through entity in another state is apportioned to and taxable by that state. If that state does not levy an individual income tax, e.g., Florida, then the income is not taxed. Conversely, if the pass-through entity suffered a loss in another state, that loss could not be deducted by the Alabama resident owners.
In 2006, an ADOR Administrative Law Division ruling, McNees, held that the Gross Income Regulation was invalid because it was inconsistent with the tax regime applicable to resident individuals who own interests in pass-through entities. Since that decision was issued, Alabama residents and their tax advisers have faced uncertainty in reporting their share of income earned by pass-through entities outside of Alabama.
Summary of the New Act
Clarifies That Taxable “Gross Income” Includes Income/Loss From Pass-Through Entities Earned Outside of Alabama: The Act modifies the statutory definition of “gross income” so that resident individuals who are either partners or members of partnerships or LLCs, shareholders of Alabama S corporations, or who are beneficiaries of estates or trusts owning an interest in one of these entities, must include their proportionate share of income or loss from the entity, regardless of where the income or loss was sourced. That is consistent with the ALD’s ruling mentioned above.
Provides a Credit for Taxes Paid to Other States: Resident individuals and estates or trusts who are owners of these pass-through entities receive a credit against their Alabama income tax liability for certain taxes paid by the entity to other states either on behalf of the nonresident owners as an income tax withholding or a composite return filing obligation, or for certain entity-level taxes levied on the pass-through entity (e.g., Texas’ margin tax and Tennessee’s excise tax). The amount of the credit is capped at the amount of income tax that Alabama would impose on that same income using applicable Alabama tax rates and would avoid double taxation of that income.
Credit for Taxes Paid to Foreign Countries: Resident individuals or beneficiaries of estates or trusts that own interests in these pass-through entities will receive an income tax credit in an amount up to 50% of like taxes paid by the pass-through entity to foreign countries. The amount of the credit is capped at the amount of tax that Alabama would impose on that same income and would avoid double taxation of that income.
Effective Date: Although this bill is retroactive for all tax years beginning after December 31, 2010, the ADOR is prohibited from assessing penalties for any understatement of income tax resulting from this retroactive application. The portions of the bill related to the foreign tax credit, however, are not effective until tax years beginning on or after January 1, 2012.