State Income Tax - Allowable or Not? It Depends.

State and local income taxes paid by a company are typically allowable costs under Government contracts (see FAR 31.205-41). In the case of 'S corps, partnerships, and LLCs however, the company does not pay state income tax (or Federal income tax for that matter). The profit (or loss) is passed through to the shareholders, partners, or members for inclusion in their own personal tax returns.

Sometimes this pass-through raises some very serious tax consequences for an individual. The amount of taxes can far outweigh the employee's compensation. Usually, the company makes additional distributions to the employee to cover his/her tax liability.

Some companies have tried to claim this extra compensation, dividend, or whatever they want to call it, as income tax and the portion that applies to state income tax, as an allowable cost. Some companies were successful, some not. The Government had no firm policy on the matter.

In 2000, the Court of Federal Claims ruled that a S Corp could be reimbursed under its cost reimbursement contracts for state income tax payments. This was overturned by the Court of Federal Appeals in 2006. In overturning the ruling, the court stated that FAR 31.205-41 pertained strictly to the legal contracting party which was not the shareholder but the corporation.

Since then, S Corp contractors have not been able to claim any state income tax costs in whatever form, under Government contracts. Presumably this ruling would also apply to partnerships and LLCs as well as S Corps.

If your company is incorporated in Alaska, Florida, Nevada, South Dakota, Texas, Washington, or Wyoming, and all your work is in-state, you don't have to worry about this. These seven states do not have a state income tax.

See State Income Tax - Allowable or Not? It Depends for additional information.