New Developments in How Alabama Taxes Resident Owners of Pass-Through Entities

Members of the ASCPA may recall that the Alabama Legislature finally stepped into the fray and resolved the issue of how resident owners of S corporations, LLCs and partnerships should be taxed on their pro rata or distributive share of income earned by their company in other states. On three occasions, the Alabama Society of CPAs, partnering with the Business Council of Alabama and other groups, successfully defeated the Alabama Department of Revenue’s (ADOR) attempts to amend its so-called “Gross Income Regulation” so that all income, from all states, would be thrown back to Alabama and taxed to the resident owners.* It was unclear to what extent the resident owners would be entitled to a credit for taxes paid by their company (or on their behalf) to other states on that income. Obviously if their company was doing business in a state such as Florida, Tennessee, Texas or Nevada, which does not levy a broad-based individual income tax, the resident owner’s Alabama income tax liability could increase substantially since no tax credit was available from those states to offset their increased Alabama tax. In the meantime, the ADOR’s Administrative Law Division ruled that the Gross Income Regulation was invalid. And there was a risk that the ruling would be applied, retroactively, against other taxpayers.

Based on compromise legislation passed in the spring 2012 regular session, retroactively effective to January 1, 2012, we were hopeful that all these issues had been resolved. Alabama residents who are owners of pass-through entities doing business in two or more states would owe Alabama income tax on their pro rata or distributive shares of the company’s worldwide income, but claim an income tax credit for certain taxes paid by their company to other states either directly or on their behalf. That applies when the other state imposes an income tax withholding/composite return obligation or levies certain entity-level taxes on the company. (Resident owners can also claim a 50% credit for non-U.S. taxes paid on foreign source income.) The legislation did not, however, address how the tax credit should be calculated.

Nevertheless, prior to the passage of Act 2012-427, the ADOR revised its Schedule CR to change the credit calculation. The change resulted in a substantial new limitation on the amount of credit available for taxes paid to other states. Because the tax credit had been calculated in the same manner since World War II, and because there was no statutory or regulatory change that provided for the form change, this revision to Schedule CR created concern among a large number of Alabama taxpayers and their advisers. Many Alabama CPAs and other tax practitioners considered the form change to constitute an unauthorized rule change, in violation of the Alabama Administrative Procedure Act (AAPA).

On September 4 — after months of discussions between a group of Alabama CPAs and other tax practitioners, the ADOR, legislative leadership, the Business Council of Alabama, and the Governor’s Office — the ADOR announced that it would withdraw the change to its 2011 Schedule CR. In addition, the department will outline the procedures for calculating the credit for taxes paid to other states through the AAPA rule-making process. Accordingly, for the 2011 and 2012 tax years, taxpayers may calculate the flow-through credit using the pre-2011 methodology. The revised form is available on the ADOR website, at www.revenue.alabama.gov. The Department also issued a second announcement, clarifying its position on the Schedule CR and taxpayers’ filing options, in a very helpful September 12 Information Release, also available on its website.

Several members of our firm were involved in drafting the legislation expanding the credit for taxes paid to other states as well as in the negotiations regarding the credit calculation. We appreciate the continued involvement and support of ASCPA President Jeannine Birmingham and the ASCPA State Taxation Committee. If you have any questions regarding any of these matters, feel free to contact Chris Grissom, Will Thistle, Bruce Ely or Jimmy Long in our SALT Practice Group or Dave Stewart in our Governmental Affairs Practice Group.

*The authors’ firm was pleased to represent several of the members of this coalition, including the ASCPA, in these efforts.

© September 2012. All rights reserved. Bruce Ely is Chair of the State & Local Tax Practice Group at Bradley Arant Boult Cummings LLP, and a longtime friend of and seminar leader for the ASCPA. Will Thistle is also a member of the firm’s SALT Practice Group, a licensed CPA, and an active member of the ASCPA’s State Taxation Committee.