State Income Tax Paid by S-Corp or LLC Shareholders

FAR (Federal Acquisition Regulation) 31.205-41 provides criteria on which taxes are allowable and which taxes are not allowable under Government contracts (see Allowability of Taxes Under Government Contracts). State income taxes required to be and are paid (or accrued) in accordance with GAAP (Generally Accepted Accounting Principles) are specifically called out as allowable costs.

 But what are the rules if you're a Subchapter S Corporation (S-Corp) or an LLC where the profits are passed directly to the shareholders or partners? The partners have to pay state income tax on their share of the profits. Can they pass the state income tax liability back to the company and claim it as an unallowable expense?

The short answer is 'no'. DCAA (Defense Contract Audit Agency) puts it this way in Chapter 68 of its Selected Areas of Cost Guidebook:

Contractors that elect Subchapter S Corporation tax status are not taxed at the corporation level and thus are not normally required to pay state or local income taxes or to accrue such tax liability. Instead, the corporate income passes through to the shareholders and is taxed on the shareholders’ personal income tax returns. Accordingly, state and local taxes that are passed through to the individual shareholders are not an expense of the corporation and as a result, are not allowable costs under Government contracts. Auditors should ensure that contractors who have elected Subchapter S tax status, or any other tax status (e.g., Limited Liability Corporation) in which taxes on the pass-through income of the corporation are required to be paid by the individual shareholders, are claiming only those taxes which are required to be paid or accrued by the contractor. Individual shareholder state and local income taxes claimed by the contractor on their pass-through income to the shareholders are unallowable in accordance with FAR 31.205-41, Taxes, and should be questioned. 

While this may seem unfair to companies that have chosen to organize as a Subchapter S Corporation or an LLC/LLP, we know of no other opinion or guidance or position that effectively refutes that taken by DCAA. Those companies could look at the positive side, the absence of state income tax expense gives them a competitive advantage when it comes to cost.