Several states allow pass-through entities to file a single composite return for all their nonresident owners. Partnerships, S corporations and limited liability companies are pass-through entities with multiple members. The profits from the entity pass through to each member, who must then declare those profits on an individual return.
Being able to file a single tax return for all members of a pass-through entity is a major convenience and offers other advantages. Before filing a composite return, however, understand the possible disadvantages as well.
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Composite Tax Preparation Savings
One obvious advantage of a composite return is that it saves each nonresident member of the pass-through entity the expense of filing an individual return necessitated by membership in the entity. In some instances, this one advantage outweighs any possible disadvantages.
An SEC-registered investment adviser, for example, may have 10 partners. If the adviser has clients in 15 states – which is likely for larger investment advisers – each partner ordinarily files a return in each state where the partnership does business.
In the example, this requires 150 highly duplicative tax returns. Instead, the partnership files a single composite return in each state that allows it. Technically, this return is the individual return that each nonresident income earner must file, except that it's a composite filing of all the individual returns on one form.
Advantages for Passive Investors
A composite return is particularly advantageous for nonresidents who are members of limited partnerships because in many instances the general partner already has the income information ready for filing and is staffed to complete the composite return with a minimum amount of effort. In some cases, the general partner may file the composite return without cost. When the general partner does charge each limited partner for the filing, it is still likely to be less than the filing costs for each investor.
Tax Rate Disadvantages
One evident disadvantage for participants in a composite tax return is that states often compute the tax for each member at the highest marginal tax rate. Sometimes, instead, the state charges the corporate tax rate.
In both cases, some participants are taxed at a higher rate than their financial circumstances would require if they filed individually. States may also limit tax credits on these composite returns or disallow net operating losses or deductions that would be allowable on the individual return.
By its group nature, the composite return does not take advantage of each participant's allowable personal exemptions.
Offsetting the Disadvantages
Although a participant in a composite return may pay at a higher tax rate in the states where she is not a resident than would be the case with individual filings, the participant's home state often allows offsetting tax credits. An additional considerable advantage is that filers of composite returns are not required to make estimated payments.
In general, however, there is no tax advantage in a composite filing. But where an individual participates in many multiple partnerships or other pass-through entities, the savings in time and individual tax preparation fees sufficiently offsets the higher tax rate and may make participation in composite returns the preferred choice.