When the 1996 Alabama legislature amended the Administrative Code provisions related to the operations of Alabama S corporations doing business in other states, it enacted changes that could result in some S corporation income being taxed twice. In order to understand how this unpleasant outcome could occur, it is necessary to dig into the way S corporations and their shareholders are taxed.
A Corporation Taxed Like A Partnership
S corporations (so called because they are governed by Subchapter S of the Internal Revenue Code) are said to be "corporations taxed like partnerships", since the corporation does not itself pay any tax. Instead, the income, loss, deductions and credits earned or incurred by the corporation "passes through" to the shareholders and is reported by the shareholders on their tax returns. The corporate income is then divided among the shareholders based on their stock ownership percentages. Furthermore, the income earned by the corporation retains its character as it is passed through; so capital gain, for example, earned by the corporation passes through to the shareholders as capital gain, and is reported by the shareholders as if they had earned the gain individually.
When the S corporation distributes its income to the shareholders as dividends, the general rule is that the dividend does not create additional taxable income for the shareholders as long as the distribution doesn't exceed the income the shareholders have been allocated and have included on their personal tax returns. The mechanism in the Code that tracks this relationship is the shareholder's basis in his S corporation stock. Basis is increased by investments the shareholder makes in the corporation, and by income or gains that are passed through to him. Basis is decreased by distributions paid out to the shareholder, and by losses or deductions that are passed through to him. If the dividend paid to a shareholder is greater than his basis in his S corporation stock, he recognizes additional income to the extent that the distribution exceeds his basis.
Let's look at some hypothetical numbers to see how all of this works. Assume that Mary forms Southpark, Inc., an Alabama S corporation, in 2007. Mary, an Alabama resident, has not invested any personal funds in Southpark, and she owns 100% of the stock of the corporation. Southpark has net income of $2,000 for the 2007 tax year which passes through to Mary and is reported on her individual return. Mary's basis in her S corporation stock at the end of 2007 (before considering any distributions) is $2,000 (the amount of income that is passed through to her). If Southpark pays a dividend to Mary of $2,000, Mary will not recognize any additional taxable income, since the distribution of $2,000 is not greater than her basis of $2,000. Immediately after the distribution, Mary's basis in her Southpark stock is $0 ($2,000 income passed through minus the $2,000 distribution). Assuming a 5% effective tax rate, Mary will have paid $100 state tax on her 2007 S corporation income (2,000 * 5%).
Income From Other States
This is the way it works for both federal and Alabama purposes when all of Southpark's income is earned in Alabama; but things start to get messy if the corporation has income from another state. Let's change the facts in the preceding paragraph by specifying that Southpark earned $1,000 of its 2007 income in Alabama, and the other $1,000 in Georgia. The entire $2,000 still passes through to Mary, but remember we said that the income retains its character, including the character of being from a specific state, so Mary will have $1,000 of Alabama S corporation income, and $1,000 of Georgia S corporation income. On her Alabama return, she will report the $1,000, and her tax paid to Alabama will be $50 (5% * 1,000). She will file a Georgia non-resident return, reporting the $1,000 of Georgia income, and (assuming that Georgia also has a 5% rate) she will pay $50 to Georgia. So far, she's paid a total of $100 in state taxes, exactly the same as when all the income was from one state. Unfortunately, though, we're not through.
Effect on Basis and Distributions
Now, let's examine how the new set of facts plays out in computing Mary's basis and in characterizing her distibutions from Southpark. For federal tax purposes, Mary will have the same basis analysis as she did with the first set of facts - her basis before considering the distribution is $2,000, and the $2,000 dividends paid are not greater than her basis, and therefore are not taxable to her. Her Alabama basis, on the other hand is only $1,000 before the distribution (the 2007 income reported in Alabama). When she receives the $2,000 distribution, Alabama law dictates that all of that distribution is treated as reducing Alabama basis, even though half of it is a distribution of income earned and taxed in Georgia; so the distribution exceeds her Alabama basis by $1,000 ($2,000 - 1,000). Mary has additional Alabama income of $1,000 from the excess distribution, and that will result in additional tax of $50 ($1,000 * 5%). Now, Mary has paid a total of $150 of state tax on the $2,000 income. The Georgia income gets doubly taxed, once in Georgia when it is earned, and again in Alabama when it is distributed.
Those readers who are more familiar with Alabama's tax structure are probably thinking right now, "Wait a minute. Isn't there a credit against Alabama tax for taxes paid to other states when the same income is reported in Alabama?"
And there is such a credit. Unfortunately, ADOR has been successful in several cases (see Alabama Department of Revenue v. Jimmie F. Smith, Jr. and Vicky Gregerson, Docket Number 90-246, 1/8/91, and Alabama Department of Revenue v. Charles E. and Dorothy J. Lesley, Docket Number 91-213, 1/26/95) arguing that
"The income earned by a corporation is taxable when earned and is separate and distinct from the dividends issued by the corporation which are taxable when declared and subsequently received by a shareholder. Thus, the dividend income reported by the Taxpayers in Alabama was not the same income on which the Taxpayers paid tax to the State of Georgia. Accordingly, no credit for the Georgia tax can be allowed ..."In other words, in our example, ADOR contends that the portion of the dividend that represents income previously taxed in Georgia is not the same income that was taxed in Georgia, so there is no credit available.
The bottom line is that shareholders of Alabama S corporations doing business in other states, as well as their tax preparers, must be alert to the fact that distributions will often be characterized differently for Alabama purposes than they are for federal purposes, and the corporation's accountants should maintain records to track Alabama basis separately from federal basis.
This page last updated 7/2/07
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